Open Book FinanceI’ve decided to put some key finance terms and definitions together. Italicized items are more or less essential. Sometimes, two definitions are supplied. The first is in “plain English” or cheatsheet format. The second, denoted by a (2) is closer to the textbook definition.

529 Plan  The most common is a 529 college savings plan.  529 Plans are state-administered, and most offer state tax advantages to contributors.  You can contribute to other state’s plans but many or may not receive the state tax advantage.  There are as many rules as states, so it is desirable to do your own research.  A good starting point is Vanguard’s site.

5&7 Plan (The 5 & 7 Plan) Plan to rescue the US from the current mortgage crisis.

alpha Measure of how an investment fund (or portfolio) outperforms compared to an index.  Alpha adjusts for risk as well as return.  A positive alpha, say +2%, indicates that the portfolio made an excess return over typical, hinting that the fund manager did a good job (or benefited from luck).  A negative alpha hints that the fund (or portfolio) underperformed.

American dream (financial definition)  Belief that each generation will be better off than the previous.  That hard work, talent, creativity and persistence will eventually payoff financially.  Many say that home ownership is part of the American dream.

ask Current amount a seller is willing to sell a stock (or other security) for.  Also called the offer.

backwardation (normal backwardation)  Condition where the current price of a futures contract is lower than the expected spot price when the contract matures. Here is a visual representation.  Backwardation is the opposite of contango.

basis point One hundredth of one percent (0.01%).  1% equals 100 basis points.  (2) Often used to describe the spread between one bond (1-year German bonds) versus another (1-year Italian bonds).

beta Measure of the amount a stock (or fund) tends to move when the market moves.  For example a beta of 2.0 means that a 1% market move often translates to a stock movement of 2%. Closely related to volatility.

bid Current amount offered to buy a stock or other security.

bid/ask spread Difference between bid and ask prices for a particular stock or security.  Wider bid/ask spreads mean you are likely to lose a little bit of money just in the buying or selling of that security.  Highly-traded securities tend to have very small spreads.  Spreads are lower during normal market hours.  After-hours traders should be cautious about large bid/ask spreads.

binary option Option that pays off a certain amount only if a condition is met.  Like a sports bet on a point spread.  Either it pays off or it doesn’t.

BitCoin  Digital currency that currently has 10 million units and will be capped at 21 million.  Currently one BTC =$12.20, but values fluctuate wildly.  Check current BitCoin prices here or get more BitCoin stats here.

black swan  Financial event that is severe, rare, and often unprecedented.  Examples include the 1987 stock market crash and 911.  Black swans mess up tidy mathematical financial formulas. (2) Black swans are related to “long tails”… 4+ sigma events that occur with much higher frequency than Gaussian models predict.

bond Investment that pays interest for a set amount of time, then returns the original investment.

business cycle (also economic cycle) Pattern of repeating economic expansion and contraction that has been recognized since 1790, and likely before.  Measured from peak to peak, the average business cycle lasts 3 to 5 years, however the business cycle started in 1991 lasted over 10 years .  (2)  The wide variability of the length, magnitude, and character of business cycles make them extremely difficult to forecast.

call option Option that pays the option owner if the underlying security (say a stock) increases in value before the option expires.

capital  Financial resources, usually money that is invested in a business, stock, ETF or other security.

capital gain  Financial gain on the sale of an asset.  If the asset has been owned for more than one year the capital gain is considered a long-term capital gain and taxes on the gain are reduced.  Capital gains on assets held one year or less are called short-term capital gains.

cash account Financial account that does not allow margin-based trading.  Some accounts like 401K and IRA accounts can only be cash accounts.  In most cases cash accounts are the preferred financial account for most investors.

certificate of deposit (CD) Financial product issued by banks and credit unions paying interest in exchange for tying up the investor’s money for a fixed period of time.  CDs are considered safe investments because they are usually backed up by the FDIC or NCUA.

classic economics Economic model that predicts the supply and demand continuously adjust towards equilibrium.  Essentially the markets balance themselves.   The business cycle is part of this balancing process.

closed-end fund (CEF) Fund that starts out with an initial investment divided into a number of shares.  New funds cannot be added to the fund nor can new shares be issues (hence the term closed).  CEFs trade on the open market like stocks and ETFs.  CEFs can vary dramatically from their NAV because they cannot be redeemed; they can merely be resold for whatever price the market cares to pay. Usually this price is far lower than the NAV.

common stock Shares that allow the owner to share in the financial fortunes of a company.  The investing term “stockalmost always means common stock.

contango Market condition where a futures contract is priced higher than the expected spot price at maturity.  Graph of contango.  Contango is the opposite of backwardation.  If you are using ETFs that used futures to bet on commodities (etc.), contango can erode or eliminate your profit — even if your predictions for spot-price movements are correct.

consumer price index (CPI) US Government’s key measure of inflation.  Used to adjust tax brackets, Social Security benefits, and TIPS (Treasury Inflation-Index Bonds).  Some investors, including me, believe that CPI figures in recent years under-represents actual US consumer inflation.  (2) Usually the term CPI stands for CPI-U (CPI for All Urban Consumers).  The less used CPI-W stands for the CPI for Urban Wage Earners and Clerical Workers.  Finally, the even less used C-CPI-U stands for the Chained CPI for All Urban Consumers.

corporate bond Bond that is issued by a corporation.  If the corporation goes bankrupt bond holders are paid any left over money before stock holders.

credit report Document showing your credit and payment history.  This includes your current loan balances and limits, any delinquencies, or past-due payments, and bankruptcy information.  Credit and payment information generally goes back 7 years.  There are 3 big credit-reporting agencies:  Experian, Equifax, and TransUnion.

credit score Number measuring your “creditworthiness”, and effecting both the interest rate you pay when borrowing and whether you can even get a loan.  Higher credit scores are better.  (FICO) Credit scores range from 300 to 850, with 720 generally considered good and 770 considered excellent.  Different credit-reporting agencies often report slightly difference credit scores.

default risk Chance that a bond will fail to meet its obligation to pay principle and/or interest.

derivative Investment contract in which the payoff depends on the behavior of an underlying benchmark.  (2) Derivatives are promises to pay out money, or other assets if certain conditions occur.  If it turns out that one party cannot pay the second party, the second person can be left holding a worthless IOU.  To minimize or eliminate this risk (called counter-party risk) some exchanges provide standardized derivatives (for example standardized options and futures contracts) where the exchange requires a degree of collateral, and if required “makes right” exchange-traded contracts.  Other OTC (over-the-counter) derivatives are traded between institutions without an exchange and expose both parties to counter-party risk.  Credit-default swaps issued by AIG, for example, would have defaulted had the US government not bailed them out.

diversification Buying a variety of different types of investments, both stock and bond, in a variety of industries to smooth out and reduce risk.  Index funds often provide a great way to diversify.

dividend Payment made by a each share of stock to its shareholders.  Some companies pay quarterly dividends, some pay annual dividends and some pay no dividends at all.

duration Similar to maturity, a more precise way to measure the behavior of a bond or bond fund to changes in interest rates.

Euro  Common currency in most of Europe (except Switzerland, Sweden, Denmark and England).

exchange-traded fund (ETF)  Fund that trades like a stock.  Typically ETFs have low expense ratios and many are based on stock indexes. ETFs are open-end funds. (2) ETF prices are usually held very close to true asset values (NAV) by arbitrage of ETF creation units.  ETF creation units are large blocks of ETF shares than can be exchanged for the ETF’s underlying securities.

exchange-traded note (ETN) Security that trades like stock, and outwardly similar to an ETF.  A big difference is ETNs are simply promises from the company that issues them.  If the issuing company cannot pay, the ETN becomes worthless.  This extra risk (called counter-party risk) makes ETNs less desirable than ETFs.

exchange-traded product (ETP) Catch-all name that includes exchange-traded funds (ETFs), exchange-traded notes (ETNs), and closed-end funds CEFs.

expense ratio The annual expenses charged by a fund.

Federal Reserve The central bank of the United States, responsible for setting short-term interest rates in a effort to manage inflation and promote maximum employment.  These two goals are frequently at odds, and there is considerable debate about how effective the Federal Reserve has been in this role.

finance The discipline of managing money, investments, and debt.

financial discipline Investing approach based primarily on maintaining a diversified asset allocation strategy.  Adjustments in investments are modest and aimed at maintaining a financial direction through methods such as rebalancing.   Other course corrections account for changes in time horizon and age.

fundamental analysis Style of investing based on fundamentals, particularly earnings.  The primary fundamental is the price-to-earnings (P/E) ratio.  Stock picking based on fundamental analysis is often called value investing.

futures contract (futures) Contract that obligates the “buyer” to buy the asset at a set price at a future date, and the “seller” to sell the asset under the same conditions.  Like options, futures are derivatives.  Unlike options, futures mandate a trade at expiration.

gearing Another term for leverage.

Great Recession Not deep enough to be a full-blown depression the continuing economical malaise of 2008-present is longer and deeper than a typical recession.  According to ShadowStats the 2011 recession is simply a continuation of the Great Recession of 2008.

hedge Taking position(s) to offset risk.  For example buying put options to temporarily reduce long equity position risks.

index Number representing the value of a bundle of securities.  Examples include the S&P500 and the Dow Jones Industrial Average.

index fund Fund that closely replicates an index by investing in the securities that make up that index.

index investing Investing style based on index-based securities like index EFTs and index mutual funds.  Advantages of index investing typically include financial diversification, lower investing fees, and tax efficiency.

interest Money paid in exchange for loaned money or deposits.  Savings accounts, CDs, money markets, and bonds are common sources of interest income.

investing Buying assets with the goal of making money.

Keynesian economics Economic model that advocates government intervention during economic lulls.  Fiscal policy actions like government spending increases (“stimulus” spending), and monetary policy actions like lowering interest rates (and recently QE and QE2) are examples of Keynesian economic attempts to combat the Great Recession.  (2)  While Keynesian policies aim to reduce or eliminate the business cycle, evidence suggests that Keynesian fiscal policy has the opposite effect.  Monetary policy, however, tends to support Keynesian predictions.  The difficultly is knowing when and how strongly to tighten or loosen the monetary flood gates.

leverage Holding more securities (assets) than you actually own by borrowing against other securities.  Also called buying on margin.  Investors with margin accounts can make these risky leveraged investments.  Similarly a mortgage is leveraged investment, but is considered a bit less risky than leveraged securities investment.  Leveraged investments move in proportion to the amount of leverage.  Normal investments are have a 1X leverage ratio (fully-invested, no leverage).  For every percent a fully-invested investment moves a leveraged investment move more by the leverage ratio.  Commonly margin accounts allow a maximum leverage of up to 4X.  So if the unleveraged investment drops 20%, the leveraged investment will drop 80%.  Be very wary of both personal leverage (margin accounts) and leveraged funds.

limit order Order where the investor chooses to buy or sell a security at a specified price.  If the security does not reach that price, there is no trade.

long (long position) Buying a security with the expectation that it will appreciate.  Long positions are by far the largest market positions.  Many investors and funds engage exclusively in long positions.

load Sales commission charged on some mutual funds (to buy and/or sell). It is best to avoid load funds.

low-cost fund Fund with a low expense ratio, typically much lower than 1%.

margin account Type of brokerage account that allows the account holder to borrow against part of the value of the securities in the account to buy additional securities (this is called a margin loan).  Often the account holder may buy up to 4X the account value worth of securities (this is called leverage).    Buying on margin magnifies risk because losses are magnified not only be the amount of leverage, but also buy the added interest cost of the margin loan.

market capitalization (market cap) Total value of a company based on multiplying the number of shares times the current share value.   Companies are frequently classified as large cap, mid cap, small cap, and micro cap.

market order Order where an investor chooses to buy or sell a security the current, best-available market price.

maturity The length of time a bond takes to pay back the original “face value” or initial amount paid to buy the bond (not including interest).  In other words, the time left until a bond matures.

Mendoza line  Borrowed from baseball jargon, the term refers to a 2% interest rate — usually on the benchmark 10-year U.S. Treasury.  A rate below the Mendoza line indicates weak economic prospects similar to how a 0.200 batting average reflects lackluster hitting.

mutual fund Fund owned by several investors who share in the gains and losses of the fund.

National Best Bid and Offer (NBBO) The bid and ask (offer) that an average investor will see when trading a stock online, unless they have level 2 quotes.

net asset value (NAV) The net value of the assets that make up  a share of a fund.

net worth The total value of all your assets minus all of your loans and debts.

no-load mutual fund Mutual fund with no sales load.  This is very desirable.

option Security that givens the owner the right to buy other securities at a fixed price up until an expiration date.  Think of an option as a grocery-store coupon that allows you buy ten cases of Pepsi for one dollar each, but it expires in one month.  This type of option is called a call option.  Another type of option is a put option, which allows the owner to fixed amount of product for a fixed price.  Options are derivatives because their value derives from the value of something else.

ordinary shares Same as common stock.

portfolio Collection of assets, securities, and in some cases debt.

put option Option that pays the option owner if the underlying security (say a stock) decreases in value before the option expires.

preferred stock (preferreds) Company-issued stock that has bond-like and stock-like characteristics.  Preferred stocks can be complicated and vary from issue to issue and company to company. Preferreds can contain unique risks.  (2) Like bonds, preferred stock rights supersede common stock in collecting money during a company bankruptcy. However bonds are first in line to collect cash.   Like stocks, preferred stocks pay dividends — dividends that are higher than common stock dividends.  Dividends must be paid on preferred stocks before any can be paid on common stock.

price-to-earnings (P/E) ratio The best way of measuring the price of a stock or group of stocks; measures the price of the investment versus the amount earned in the past 12 months. High price-to-earnings ratio mean that an investment is expensive (high-priced), while low P/Es mean it is cheap.  Low P/E investments are sometimes called value investments.

risk The chance that one or more investments will lose some or all their value. (2) The standard-deviation of a investment or investment portfolio.  One of many measures of historic (or predicted) variation of asset value.

security Tradeable financial investment such as a stock, bond, ETF, or mutual fund.

share See stock.

short  (short selling) Taking a position in a security with the assumption that it will fall in value.  To short a stock is to borrow stock and sell it, collecting some cash.  If the value of the stock decreases the short seller can by it back cheaply and keep the cash difference.  If the stock appreciates the short seller has a problem; they need to raise extra cash to buy the stock back.  (2) Short-selling has unlimited downside risk, and limited upside potential.   Short sellers pay interest to borrow stocks and must also pay out any dividends the stock pays to the party that lent the stock.

speculation Financial approach based more on intuition and other factors more than fundamental research.   Often there is a lot of gray area between investing and speculation.  Speculative choices tend to be short-term, impulsive, rapid., and diversification-reducing.  Many, if not most, investing changes involve a degree of speculation.  In my opinion it is desirable to maintain a high degree of discipline, and a low degree of speculation in investing and financial choices.

spread Difference in interest rates between two bonds (or bond types).  For example, “There is a mere 7 basis point spread between 2-year Treasurys and 2-year AAA-rated corporate bonds.”

stock (share of stock) Investment representing a small piece of a company.

stock exchange Place where stocks, bonds, options, ETFs, and other securities are bought and sold.   Exchanges offer a advantage over over-the-counter (OTC) trades because they automatically pair up buyers and sellers.  If Alice wants to buy 100 shares of IBM and Bob wants Charlie want to sell 100 shares, the exchange will find the best price between Bob and Charlie and close the deal for Alice.  If Alice wants to sell 200 shares of Apple,  but Bob wants to sell 100 shares, and Daniel wants to sell 100 shares, the exchange can pool Bob’s and Daniel’s shares together to sell to Alice.

Major US stock exchanges include the NYSE (New York Stock Exchange), NASDAQ, and AMEX.  However there are many small US stock exchanges as well including the Boston Stock Exchange (BSE), and Chicago Stock Exchange (CHX). Exchanges can be physical trading floors, computerized trading networks, or a mix of both. Computerized stock exchanges are rapidly replacing physical stock exchanges.

stock market Market where shares are traded at stock exchanges or over-the-counter. (2) The stock market includes the primary market were new stock is issue, often via IPO (initial public offerings), and the secondary market with involves all subsequent trading of these stocks.  The vast majority of stock trading occurs in the secondary market at stock exchanges.

technical analysis Various techniques some investors (speculators?) use to pick stocks, largely based on patterns, and distinctly different from fundamental analysis.  Technical indicator jargon includes head-and-shoulders, cup-and-handle, over-bought and over-sold, support levels, trading volume, and moving-average indicators.

time horizon Fancy financial term for how long it will be until you are likely to need to cash out some or all of your investments.  The time horizon for your child’s college fund is pretty simple… how long until they are expected to graduate high school.   The time horizon for when you and/or your spouse retire may be a little harder to guesstimate.  Nevertheless an estimate of when you are most likely to “need the money” can be a great help in financial planning.  Generally longer time horizons benefit from greater risk (via higher stock to bond ratios) and shorter time horizons benefit from lower risk (lower stock to bond ratios).

Tobin tax  A tax proposed by James Tobin on spot currency exchanges of 0.5%.  Some have tried to re-imagine this tax as applicable to other transactions.

tracking error The amount an index fund misses tracking its index.

Treasury bond (note or bill) Bond issued by the US Government, considered by many to be the safest investment on the planet.  Treasury bonds have the longest maturities, followed by notes, followed by bills.

volatility Fluctuation in value.  (2)  Standard deviation (σ) is a common measure of volatility.

yield curve Chart showing interest rate versus maturity for bonds, usually Treasure bonds.  Typically yields increase as maturities increase.

zero-coupon bond Type of bond that pays a lump sum at maturity, rather than paying interest along the way.  Unfortunately, taxes are due every year for accrued interest that has yet to be paid.


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