Glossary of Financial Terms
The definitions contained in this glossary come from a variety of sources. Some were written by Lee H. Anke, CEO Prudent Investors Network, some were obtained from the website, www.Investopedia.com and some came from “Investing and Managing Trusts” by John Train and Thomas A. Melfe.
A defined contribution plan that may be established by a company for retirement. Employees may allocate a portion of their salaries into this plan, and contributions are excluded from their income for tax purposes (with limitations). Contributions and earnings will compound tax deferred. Withdrawals from a 401(k) plan are taxed as ordinary income, and may be subject to an additional 10 percent federal tax penalty if withdrawn prior to age 59½.
A defined contribution plan that may be established by a nonprofit organization or school for retirement. Employees may allocate a portion of their salaries into this plan, and contributions are excluded from their income for tax purposes (with limitations). Contributions and earnings will compound tax deferred. Withdrawals from a 403(b) plan are taxed as ordinary income, and may be subject to an additional 10 percent federal tax penalty if withdrawn prior to age 59½.
Adjusted Gross Income (AGI)
An interim calculation in the computation of income tax liability. It is computed by subtracting certain allowable adjustments from gross income.
A person appointed by the court to settle an estate when there is no will.
The return from an investment after the effects of taxes have been taken into account.
A portfolio consisting of assets with smaller capitalization stocks, high price/earnings ratios and low yields with low cash reserves. These assets are typically more volatile than the market in general. A mutual fund with an aggressive growth investment objective is geared toward substantial capital gains.
A measure of volatility based on the returns of a chosen benchmark. Alpha is the excess return of the asset relative to its benchmark.
Alternative Minimum Tax
A method of calculating income tax that disallows certain deductions, credits, and exclusions. This was intended to ensure that individuals, trusts, and estates that benefit from tax preferences do not escape all federal income tax liability. People must calculate their taxes both ways and pay the greater of the two.
An insurance-based contract that provides future payments at regular intervals in exchange for current premiums. Annuity contracts are usually purchased from insurance companies, brokerage firms, banks, or credit unions. Any guarantees are contingent on the claims-paying ability of the issuing company.
Anything owned that has monetary value.
The process of repositioning assets in a portfolio to maximize potential return for a particular level of risk. This process is usually done using the historical performance of the asset classes within sophisticated mathematical models. Asset allocation does not eliminate or guarantee against the risk of investment loss, but may reduce it; it is a method used to help manage investment risk.
A category of investments with similar characteristics.
The examination of the accounting and financial documents of a firm by an objective professional. The audit is done to determine the records’ accuracy, consistency, and conformity to legal and accounting principles.
Balanced Mutual Fund
A mutual fund whose objective is a balance of stocks and bonds. Balanced funds tend to be less volatile than stock-only funds and, long term, higher returning than bond-only funds.
When the stock market appears to be declining overall, it is said to be a bear market. The technical definition of a bear market is a 20%-or-more loss over two-or-more months.
A standard against which the performance of a security, mutual fund or investment manager can be measured. An example of an equity benchmark is the Standard & Poor’s 500 Index.
A person named in a life insurance policy, annuity, will, trust, or other agreement to receive a financial benefit upon the death of the owner. A beneficiary can be an individual, company, organization, and so on.
As defined by Morningstar, beta is “a measure of a fund’s sensitivity to market movements.” The beta is measured relative to either the market, or a benchmark (typically the Standard & Poor’s 500 Index). The market’s or benchmark’s beta is defined as 1.00. A fund or stock having a beta of 1.10 is therefore 10% more volatile than the benchmark. If the benchmark rose 10%, this fund would typically rise 11%. Beta cuts both directions, however. If the benchmark fell 10%, a fund with a beta of 1.10 would be expected to lose 11%. Conversely, a beta of 0.85 would indicate that the fund is 15% less volatile than the benchmark. Beta differs from the standard deviation in that standard deviation is an absolute measure of volatility whereas beta measures a stock’s or fund’s volatility relative to its benchmark.
The common stock of a company with a long history of profitability and consistent dividend payments.
A bond is evidence of a debt in which the issuer promises to pay the bondholders a specified amount of interest and to repay the principal at maturity. Bonds are usually issued in multiples of $1,000.
The net value of a company’s assets, less its liabilities and the liquidation price of its preferred issues. The net asset value divided by the number of shares of common stock outstanding equals the book value per share, which may be higher or lower than the stock’s market value.
When the stock market appears to be advancing overall, it is said to be a bull market. The technical definition of a bull market is a 20%-or-more gain over two months or more.
A buy-sell agreement is an arrangement between two or more parties that obligates one party to buy the business and another party to sell the business upon the death, disability, or retirement of one of the owners.
Capital Gain or Loss
The difference between the sales price and the purchase price of a capital asset. When that difference is positive, the difference is referred to as a capital gain. When the difference is negative, it is a capital loss.
Short-term investments, such as U.S. Treasury securities, certificates of deposit, and money market fund shares that can be readily converted into cash with little risk of loss.
Cash Surrender Value
The amount that an insurance policyholder is entitled to receive when he or she discontinues coverage. Policyholders are usually able to borrow against the surrender value of a policy from the insurance company. Policy loans that are not repaid will reduce the policy’s death benefit and cash value by the amount of any outstanding loan balance plus interest.
CERTIFIED FINANCIAL PLANNER® Practitioner
A credential granted by the Certified Financial Planner Board of Standards, Inc. (Denver, CO) to individuals who complete a comprehensive curriculum in financial planning and ethics. CFP®, CERTIFIED FINANCIAL PLANNER ®and federally registered CFP (with flame logo)® are certification marks owned by the Certified Financial Planner Board of Standards. These marks are awarded to individuals who successfully complete the CFP Board’s initial and ongoing certification.
Certified Public Accountant (CPA)
A professional license granted by a state board of accountancy to an individual who has passed the Uniform CPA Examination (administered by the American Institute of Certified Public Accountants) and has fulfilled that state’s educational and professional experience requirements for certification.
Charitable Lead Trust
A trust established for the benefit of a charitable organization under which the charitable organization receives income from an asset for a set number of years or for the trustor’s lifetime. Upon the termination of the trust, the asset reverts to the trustor or to his or her designated heirs. This type of trust can reduce estate taxes and allows the trustor’s heirs to retain control of the assets.
Charitable Remainder Trust
A trust established for the benefit of a charitable organization under which the trustor receives income from an asset for a set number of years or for the trustor’s lifetime. Upon the termination of the trust, the asset reverts to the charitable organization. The trustor receives a charitable contribution deduction in the year in which the trust is established, and any gains on assets placed in the trust are exempt from capital gains tax.
Chartered Financial Consultant (ChFC)
A professional financial planning designation granted by The American College (Bryn Mawr, PA) to individuals who complete a comprehensive curriculum in financial planning. Prerequisites include passing a series of written examinations, meeting specified experience requirements and maintaining ethical standards. The curriculum encompasses wealth accumulation, risk management, income taxation, planning for retirement needs, investments, estate and succession planning.
Chartered Life Underwriter (CLU)
A professional designation granted by The American College to individuals who complete a comprehensive curriculum focused primarily on risk management. Prerequisites include passing a series of written examinations, meeting specified experience requirements, and maintaining ethical standards. The curriculum encompasses insurance and financial planning, income taxation, individual life insurance, life insurance law, estate and succession planning, and planning for business owners and professionals.
An investment vehicle wherein an investment company can raise a fixed amount of capital during its initial public offering (IPO) by issuing shares which represent an interest in a group of similar stocks representing a certain industry, sector, region, etc. Closed-end funds are quite different from the more common, open-end mutual funds.
The Consolidated Omnibus Budget Reconciliation Act is a federal law requiring employers with more than 20 employees to offer terminated or retired employees the opportunity to continue their health insurance coverage for 18 months at the employee’s expense. Coverage may be extended to the employee’s dependents for 36 months in the case of divorce or death of the employee.
Coinsurance or Co-Payment
The amount an insured person must pay for a covered medical and/or dental expense if his or her insurance doesn’t provide 100 percent coverage.
The generic term for goods such as grains, foodstuffs, livestock, oils, and metals which are traded on national exchanges. These exchanges deal in both “spot” trading (for current delivery) and “futures” trading (for delivery in future months).
A unit of ownership in a corporation. Common stockholders participate in the corporation’s profits or losses by receiving dividends and by capital gains or losses in the stock’s share price.
State laws vary, but generally all property acquired during a marriage — excluding property one spouse receives from a will, inheritance, or gift — is considered community property, and each partner is entitled to one half. This includes debt accumulated. There are currently nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Interest that is computed on the principal and on the accrued interest. Compound interest may be computed continuously, daily, monthly, quarterly, semiannually, or annually.
Consumer Price Index
The U.S. Department of Labor’s main indicator of inflation. The Consumer Price Index is calculated each month from the cost of some 400 retail items in urban areas throughout the United States.
Similar to diversification or covariance, correlation is a measure of how similar the returns or movements of two or more assets are.
A table comparing the correlation of each investment against all other assets in the portfolio. High correlations show a lack of diversification. Low or negative correlations show good diversification.
An amount that can be subtracted from gross income, from a gross estate, or from a gift, thereby lowering the amount on which tax is assessed.
Defined Benefit Plan
A qualified retirement plan under which a retiring employee will receive a guaranteed retirement fund, usually payable in installments. Annual contributions may be made to the plan by the employer at the level needed to fund the benefit. The annual contributions are limited to a specified amount, indexed to inflation.
Defined Contribution Plan
A retirement plan under which the annual contributions made by the employer or employee are generally stated as a fixed percentage of the employee’s compensation or company profits. The amount of retirement benefits is not guaranteed; rather, it depends upon the investment performance of the employee’s account.
Whereas a security represents ownership of something, a derivative can represent ownership of either a security of an invented category like a put or call on a stock, bond, currency, etc. Derivatives represent a contract between two parties and their value depends on fluctuations in the price of the underlying asset. Most derivatives are highly leveraged.
A trustee can choose to act or not act on certain items where discretion is given. They may decide to pay a beneficiary interest and dividends or not if discretionary powers have been granted to the trustee. In terms of investing, a broker who is given discretionary authority to change investments within a portfolio will typically be able to make changes he/she sees fit while taking the mood and momentum of the markets into account–without having to contact the trustee first.
Investing in different companies, industries, or asset classes in an attempt to limit overall risk. Of course, diversification cannot eliminate or guarantee against the risk of investment losses; it is a method used to help manage investment risk. Diversification may also mean the participation of a large corporation in a wide range of business activities.
A pro rata portion of earnings usually distributed in cash by a corporation to its stockholders. In preferred stock, dividends are usually fixed; with common shares, dividends may vary with the fortunes of the company.
Dollar Cost Averaging
A system of investing in which the investor buys a fixed dollar amount of securities at regular intervals. The investor thus buys more shares when the price is low and fewer shares when the price rises, and the average cost per share is lower than the average price per share. Dollar cost averaging does not ensure a profit or prevent a loss. Such plans involve continuous investments in securities regardless of fluctuating prices. You should consider your financial ability to continue making purchases during periods of low and high price levels. However, this can be an effective way for investors to accumulate shares to help meet long-term goals.
A lowered or negative change in rating of a security such as the S&P downgrade of treasuries from AAA to AA+.
“Risk,” to most investors, could best be defined as the likelihood of taking a loss on one’s investment. Unfortunately, the most common measures of “risk” found in investment literature merely gauge the overall volatility (either up or down) of a security’s price. Thus, the oft-quoted beta and standard deviation give equal weight to a fund’s propensity to generate very large gains as to its potential to deliver painful losses. We (PIN) feel it is more meaningful to employ a measure of risk that selectively focuses on a security’s tendency to expose investors to losses and ignores upside volatility. (What investor, after all, lies awake at night fearing that his investment portfolio might suddenly surge upward in price?).
A statistical result from the analysis of the risk and return for a given set of assets that indicates the balance of assets that may, under certain assumptions, achieve the best return for a given level of risk.
Typically refers to countries in the early stages of economic development where there are expectations for rapid growth (as determined by GDP). These countries are identified by the International Finance Corporation (IFC).
Employer-Sponsored Retirement Plan
A tax-favored retirement plan that is sponsored by an employer. Among the more common employer-sponsored retirement plans are 401(k) plans, 403(b) plans, simplified employee pension plans, and profit-sharing plans.
The value of a person’s ownership in real property or securities; the market value of a property or business, less all claims and liens against it.
Employee Retirement Income Security Act (ERISA)
The Employee Retirement Income Security Act is a federal law covering all aspects of employee retirement plans. If employers provide plans, they must be adequately funded and provide for vesting, survivor’s rights, and disclosures.
ESOP (employee stock ownership plan)
A defined contribution retirement plan in which company contributions must be invested primarily in qualifying employer securities.
Activities coordinated to provide for the orderly and cost-effective distribution of an individual’s assets at the time of his or her death. Estate conservation often includes the use of wills and trusts.
Upon the death of a decedent, federal and state governments impose taxes on the value of the estate left to others (with limitations).
Executive Bonus Plan
The employer pays for a benefit that is owned by the executive. The bonus could take the form of cash, automobiles, life insurance, or other items of value to the executive.
A person named by the probate courts or the will to carry out the directions and requests of the decedent.
A person who is placed in a position of trust and who is legally authorized to make decisions on behalf of a beneficiary.
Income from investments, such as CDs, Social Security benefits, pension benefits, some annuities, or most bonds, that is the same every month.
Assets, such as CDs, some annuities, and most bonds, that pay out the same amount on a periodic basis. Such assets typically guarantee to pay back the original “dollars” invested at a given date in the future, or over a given period of time.
An approach to the stock market in which specific factors – such as the price-to-earnings ratio, yield, or return on equity – are used to determine what stock may be favorable for investment.
A federal tax levied on the transfer of property as a gift. This tax is paid by the donor. In 2009, the first $13,000 a year from a donor to each recipient is exempt from tax. Most states also impose a gift tax. The gift tax exemption is indexed for inflation.
An investment objective that seeks investment opportunities in the United States and abroad.
An investment objective that favors returns over safety or guaranteed returns. Growth-oriented investments typically have relatively high price-earnings ratios and lower dividend yields.
Offsetting an investment with a contract in a related security to reduce your exposure to risk. Futures contracts, short sales and puts are examples of hedges one may buy.
A will entirely in the handwriting of the testator. Without witnesses, holographic wills are valid and enforceable only in some states.
A person or entity to whom either all or a portion of a trust’s income is owed.
An investment portfolio designed to mimic the performance of a specific index like the S&P 500 Index, for example.
Individual Retirement Account (IRA)
Contributions to a traditional IRA are deductible from earned income in the calculation of federal and state income taxes if the taxpayer meets certain requirements. The earnings accumulate tax deferred until withdrawn, and then the entire withdrawal is taxed as ordinary income. Individuals not eligible to make deductible contributions may make nondeductible contributions, the earnings on which would be tax deferred.
An increase in the price of products and services over time. The government’s main measure of inflation is the Consumer Price Index.
Initial Public Offering (IPO)
The issuance of stock by a private company to the public for the very first time. Typically, smaller companies interested in generating more capital in an effort to grow their business will issue stock through an underwriting firm.
As opposed to tangible assets like real estate, investments including stocks and bonds represent ownership.
A person who dies without leaving a valid will. State law then determines who inherits the property or serves as guardian for any minor children.
A broad class of assets with similar characteristics. The five investment broadest categories include cash equivalents, fixed principal, equity, debt, and tangibles. Some analytical services (Morningstar, for example) break down various investments into much more refined “categories.”
A trust that may not be modified or terminated by the trustor after its creation.
Joint and Survivor Annuity
Most pension plans must offer this form of pension plan payout that pays over the life of the retiree and his or her spouse after the retiree dies. The retiree and his or her spouse must specifically choose not to accept this payment form.
Co-ownership of property by two or more people in which the survivor(s) automatically assumes ownership of a decedent’s interest.
Jointly Held Property
Property owned by two or more persons under joint tenancy, tenancy in common, or, in some states, community property.
This retirement plan, named for Eugene Keogh, is designed for self-employed individuals. The contribution amount is indexed annually for inflation.
Generally includes companies that have a total market capitalization (the number of shares outstanding multiplied by the price per share) of $10 billion to $200 billion.
Any claim against the assets of a person or corporation: accounts payable, wages, and salaries payable, dividends declared payable, accrued taxes payable, and fixed or long-term obligations such as mortgages, debentures, and bank loans.
Limited partnerships pool the money of investors to develop or purchase income-producing properties. When the partnership subsequently receives income from these properties, it passes the income on to its investors as dividend payments.
The ease with which an asset or security can be converted into cash.
A trust created by a person during his or her lifetime.
The sales commission typically offered by a mutual fund company to a broker. A sales commission can be paid up front as a front-end load and is a percentage of the amount invested. Back-end loads are charged to an investor if a fund is sold within a specified time period (usually within 5 to 10 years). In these cases, the sales commission is often highest in the first year and will decrease annually until it reaches zero. There are also funds for which there is no sales commission–known as no-load funds. In fee-based accounts, mutual funds are purchased as no-load funds since collecting a sales commission AND a fee is known as “double dipping”–which is illegal.
To be long in the market or in a stock implies that you are optimistic or bullish about your investment holdings.
The disbursement of the entire value of an employer-sponsored retirement plan, pension plan, annuity, or similar account to the account owner or beneficiary. Lump-sum distributions may be rolled over into another tax-deferred account.
Marginal Tax Bracket
The range of taxable income that is taxable at a certain rate. Currently, there are six marginal tax brackets: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent.
A provision of the tax codes that allows all assets of a deceased spouse to pass to the surviving spouse free of estate taxes. This provision is also referred to as the “unlimited marital deduction.” The marital deduction may not apply in the case of noncitizens.
Market Capitalization (Market Cap)
A company’s total outstanding shares multiplied by the stock price per share.
Generally includes companies with a market capitalization of $50 million to $300 million.
Generally includes companies with a market capitalization of $1 billion to $10 billion.
Modern Portfolio Theory (MPT)
Morningstar states, “Modern Portfolio Theory is the standard financial and academic method for assessing the risk of an investment, relative to a benchmark.” Though very complex math underlies the theory, in its simplest form, MPT states that, given several investment alternatives of equal probable return, a rational investor will choose the one with the lowest risk. Conversely, if several investment alternatives possess a similar risk profile, a rational investor will choose the one with the highest return. On the surface, that sounds like one is stating the obvious. However, it imposes a discipline upon a prudent investor that is generally disregarded by the investment public – the prudent investor must monitor the risk of his investments in a consistent, quantifiable manner (see the risk measurement entries herein such as beta, downside risk, standard deviation and semi-standard deviation). Most investors are largely unaware that such measures of risk are readily available. With risk as well as return information before him, the prudent investor is in a position to control, rather than be controlled by, the risk in his portfolio.
One additional fundamental principle underlying MPT is that price movements in different asset classes are driven by different economic factors. Hence, over a short period, one asset class may be moving up in price at the same time another is moving down. Yet, over the long-term, both may tend to average, say, a 10% growth rate. By investing in both asset classes, rather than one or the other, the non-correlated price volatility of the two classes will tend to offset each other over the short term resulting in a portfolio that grows smoothly at a 10% rate over the long term — experiencing considerably less short-term volatility than either of the individual assets of which it consists. “Diversification” within a single asset class (such as large-company U.S. stocks) is really no diversification at all. MPT has shown that diversification across multiple asset classes is fundamental to the management and control of portfolio risk. Few investors are immune to the anxiety that accompanies a typical 30% to 40% loss in a bear market. Proper diversification has been shown to substantially reduce the potential for such deep losses.
Money Market Fund
A mutual fund that specializes in investing in short-term securities and tries to maintain a constant net asset value of $1. Money-market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any government agency. Although money market funds seek to preserve the value of your investment at $1 per share, it is possible to lose money when investing in a money market fund.
A debt security issued by municipalities. The income from municipal bonds is usually exempt from federal income taxes. It may also be exempt from state income taxes in the state in which the municipal bond is issued. Some municipal bond interest could be subject to the federal alternative minimum tax. If you sell a municipal bond at a profit, you could incur capital gains taxes. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance. The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost.
Municipal Bond Fund
A mutual fund that specializes in investing in municipal bonds. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.
A collection of stocks, bonds, or other securities purchased and managed by an investment company with funds from a group of investors. Mutual funds are sold only by prospectus. One should consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional.
Net Asset Value
The per-share value of a mutual fund’s current holdings. The net asset value is calculated by dividing the net market value of the fund’s assets by the number of outstanding shares.
Pooled Income Fund
A trust created by a charitable organization that combines the contributions of several donors and distributes income to those donors based on the earnings of the trust. The trust is managed by the charitable organization, and contributions are partially deductible for income tax purposes.
All the investments held by an individual or a mutual fund.
A class of stock with claim to a company’s earnings, before payment can be made on the common stock, and that is usually entitled to priority over common stock if the company liquidates. Generally, though not always, preferred stocks pay dividends at a fixed rate and behave more like infinite-maturity fixed-income instruments than like equities.
A legal agreement arranged before marriage stating who owns property acquired before marriage and during marriage and how property will be divided in the event of divorce. ERISA benefits are not affected by prenuptial agreements.
Price/Earnings Ratio (P/E Ratio)
The market price of a stock divided by the company’s annual earnings per share. Because the P/E ratio is a widely regarded yardstick for investors, it often appears with stock price quotations.
In a security, the principal is the amount of money that is invested, excluding earnings. In a debt instrument such as a bond, it is the face amount.
The court-supervised process in which a decedent’s estate is settled and distributed.
An agreement under which employees share in the profits of their employer. The company makes annual contributions to the employees’ accounts. These funds usually accumulate tax deferred until the employee retires or leaves the company.
A document provided by investment companies to prospective investors. The prospectus gives information needed by investors to make informed decisions prior to investing in a specific mutual fund, variable annuity, or variable universal life insurance. The prospectus includes information on the minimum investment amount, the investment company’s objectives, past performance, risk level, sales charges, management fees, and any other expense information about the investment company, as well as a description of the services provided to investors in the investment company.
Qualified Domestic Relations Order (QDRO)
At the time of divorce, this order would be issued by a state domestic relations court and would require that an employee’s ERISA retirement plan accrued benefits be divided between the employee and the spouse.
Qualified Retirement Plan
A pension, profit-sharing, or qualified savings plan that is established by an employer for the benefit of the employees. These plans must be established in conformity with IRS rules. Contributions accumulate tax deferred until withdrawn and are deductible to the employer as a current business expense.
Rate of Return
The gain or loss of an investment over a specific time period. A rate of return can be expressed as a percentage increase (or decrease) above and beyond the initial investment amount.
Real Estate Investment Trust (REIT)
An investment that sells like a stock and invests in real estate either through actual properties or through mortgage contracts.
The return of an asset as compared to its benchmark.
A person or entity with the legal rights to inherit a trust’s principal at the termination of the trust.
A trust in which the creator reserves the right to modify or terminate the trust.
The chance that an investor will lose part or all the principal he put into an investment.
Refers to the assumption that rational investors will choose the security with the least risk if they can maintain the same return. As the level of risk goes up, so must the expected return on the investment.
Risk-Free Rate of Return
Although there is a negligible amount of risk involved, the ninety-day Treasury bill rate of return is used as the benchmark indicating the ultimate level of investment safety.
A method by which an individual can transfer the assets from one retirement program to another without the recognition of income for tax purposes. The requirements for a rollover depend on the type of program from which the distribution is made and the type of program receiving the distribution.
A nondeductible IRA that allows tax-free withdrawals when certain conditions are met. Income and contribution limits apply.
Evidence of an investment, either in direct ownership (as with stocks), creditorship (as with bonds), or indirect ownership (as with options).
Our (PIN’s) preferred measure of risk is the semi-standard deviation. It is computed in a manner similar to the standard deviation; however, unlike standard deviation (which includes both upside and downside volatility around the mean), the semi-standard deviation disregards all volatility except deviations resulting in actual losses in value. A large semi-standard deviation, therefore, indicates that an investment has historically taken painfully large losses from time to time. It therefore differs from the standard deviation and beta in that it provides the investor with a sense of how likely it is that the investment he is considering will expose him to actual losses – a far more critical piece of information than the investment’s “volatility” around its average return.
Scatter Diagrams (Scatter Plots)
Scatter diagrams are the most useful tool PIN has found for evaluating risk and portfolio diversification. At a glance, a scatter diagram can tell an investor not just how rewarding an investment has been in terms of returns, but also how much risk of loss the investors have been exposed to in achieving those returns. In the sample scatter diagram below, note that the horizontal axis represents an investment’s semi-standard deviation – which measures the size of actual losses experienced over the period of the study. The vertical axis gives the investment’s average investment return over the period. The intersection of the vertical and horizontal cross hairs marks the risk and return characteristics of the benchmark. A benchmark is typically the average of the peer group of all funds belonging to the same category as the fund you are evaluating. It may also be an index. The cross hairs centered on the benchmark conveniently divide the diagram into four quadrants. Funds in the upper-right quadrant (such as the orange one in this example) have provided above-average returns, but have exposed their investors to serious losses along the way. In other words, this is a speculative manager who tends to alternate between “home runs” and “strike outs” (high returns one year and losses the next).
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The lower-right quadrant represents the worst of all combinations – the fund manager represented by the red dot exposed his investors’ capital high risk of loss (presumably attempting to achieve high gains). Unfortunately, he took the losses typical of such risk, yet was unable to offset them with greater gains – his average annual return has been a loss! The “orange” manager could well be in this position next year if the risks he is taking go against him.
A fund that fell into the lower-left quadrant would have also provided below-average returns, but his lower returns are at least somewhat justified in that he exposed his investors to fewer losses along the way. The yellow dot on the left margin represents the money market or bank with little or no risk of loss, but commensurately low returns.
The best of all worlds is the upper-left quadrant, or what we like to call the “Prudent Quadrant.” Managers in that quadrant exposed their investors to much smaller losses, yet provided them with above-average returns. The green dot represent funds that Modern Portfolio Theory would say rational or prudent investors would seek — funds with good returns (not speculative returns, but “good” returns) and below-average risk.
Simplified Employee Pension Plan (SEP)
A type of plan under which the employer contributes to an employee’s IRA. Contributions may be made up to a certain limit and are immediately vested.
An insurance-based contract that provides future payments at regular intervals in exchange for current premiums. Generally used as a supplement to retirement income and pays over the life of one individual, usually the retiree, with no rights of payment to any survivor.
Generally includes companies with a market capitalization of $100 million to $900 million.
An arrangement under which two parties (usually a corporation and employee) share the cost of a life insurance policy and split the proceeds.
An IRA designed for a couple when one spouse has no earned income. The maximum combined contribution that can be made each year to and IRA and a spousal IRA is $10,000 in 2009 or 100 percent of earned income, whichever is less. The total may be split between the two IRAs as the couple wishes, provided that the contribution to either IRA does not exceed the maximum annual contribution limit ($5,000 in 2009).
The standard deviation is a measure of the volatility of an investment’s returns around its average return. Roughly two-thirds of the time, an investment’s returns will fall within a range extending from one standard deviation below its average return, to one standard deviation above its average. So, if an investment’s average annual return were 10% and its standard deviation were 13%, then on average two of every three years the investment’s return would fall between a loss of 3% and a gain of 23% — the average return of 10% minus 13% (one standard deviation) or plus 13%. Approximately one year out of three years, the investment’s returns would fall outside that range – i.e., losses worse than 3% or gains greater than 23%. An investment with a small standard deviation therefore has more consistent and predictable returns (a narrower range of returns) from year to year. Ninety-five percent of the time, an investment’s returns will fall within plus or minus two standard deviations of its average.
Income taxes are typically charged in incremental brackets. The first X dollars of income might be subject to, say, a 15% tax rate; the next Y dollars of income to a 20% rate; the next Z dollars to a 25% rate; etc., up to the earner’s last dollar earned. The tax rate applied to the last dollar earned is referred to as his “tax bracket.”
Tax credits, the most appealing type of tax deductions, are subtracted directly, dollar for dollar, from your income tax bill.
Interest, dividends, or capital gains that grow untaxed in certain accounts or plans until they are withdrawn.
Under certain conditions, the interest from bonds issued by states, cities, and certain other government agencies is exempt from federal income taxes. In many states, the interest from tax-exempt bonds will also be exempt from state and local income taxes. If you sell a tax-exempt bond at a profit, you could incur capital gains taxes. Some tax-exempt bond interest could be subject to the federal alternative minimum tax. The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost.
The amount of income used to compute tax liability. It is determined by subtracting adjustments, itemized deductions or the standard deduction, and personal exemptions from gross income.
An approach to investing in stocks in which a stock’s past performance is mapped onto charts. These charts are examined to find familiar patterns to use as an indicator of the stock’s future performance.
Tenancy in Common
A form of co-ownership. Upon the death of a co-owner, his or her interest passes to the designated beneficiaries and not to the surviving owner or owners.
Term life insurance provides a death benefit if the insured dies. Term insurance does not accumulate cash value and ends after a certain number of years or at a certain age.
A trust established by a will that takes effect upon death.
One who has made a will or who dies having left a will.
The total of all earnings from a given investment, including dividends, interest, and any capital gain.
A legal entity created by an individual in which one person or institution holds the right to manage property or assets for the benefit of someone else. Types of trusts include: Testamentary Trust – A trust established by a will that takes effect upon death; Living Trust – A trust created by a person during his or her lifetime; Revocable Trust – A trust in which the creator reserves the right to modify or terminate the trust; Irrevocable Trust – A trust that may not be modified or terminated by the trustor after its creation
An individual or institution appointed to administer a trust for its beneficiaries.
A method of transferring retirement plan assets from one employer’s plan to another employer plan or to an IRA. One benefit of this method is that no federal income tax will be withheld by the trustee of the first plan.
The creator of a trust.
A legal abbreviation for “under agreement”.
A legal abbreviation for “under deed”.
Universal Life Insurance
A type of life insurance that combines a death benefit with a savings element that accumulates tax deferred at current interest rates. Under a universal life insurance policy, the policyholder can increase or decrease his or her coverage, with limitations, without purchasing a new policy.
A legal abbreviation for “under will”.
An investment strategy that focuses on purchasing companies that appear to be “cheap” in terms of their underlying assets and fundamentals.
Variable Universal Life Insurance
A type of life insurance that combines a death benefit with an investment element that accumulates tax deferred. The account value can be allocated into a variety of investment subaccounts. The investment return and principal value of the variable subaccounts will fluctuate; thus, the policy’s account value, and possibly the death benefit, will be determined by the performance of the chosen subaccounts and is not guaranteed. Withdrawals may be subject to surrender charges and are taxable if the account owner withdraws more than his or her basis in the policy. Policy loans or withdrawals will reduce the policy’s cash value and death benefit and may require additional premium payments to keep the policy in force. There may also be additional fees and charges associated with a VUL policy.
The range of price swings of a security or market over time.
Welfare Benefit Plan
An employee benefit plan that provides such benefits as medical, sickness, accident, disability, death, or unemployment benefits.
Whole Life Insurance
A type of life insurance that offers a death benefit and also accumulates cash value tax deferred at fixed interest rates. Whole life insurance policies generally have a fixed annual premium that does not rise over the duration of the policy. Whole life insurance is also referred to as “ordinary” or “straight” life insurance. Policy loans will reduce the cash value by the amount of any outstanding loan balance plus interest.
A legal document that declares a person’s wishes concerning the disposition of property, the guardianship of his or her children, and the administration of the estate after his or her death.
Generally, the yield is the amount of current income provided by an investment. For stocks, the yield is calculated by dividing the total of the annual dividends by the current price. For bonds, the yield is calculated by dividing the annual interest by the current price. The yield is distinguished from the return, which includes price appreciation or depreciation.
This type of bond makes no periodic interest payments but instead is sold at a steep discount from its face value. Bondholders receive the face value of their bonds when they mature.