“Looking over this year’s prospectus I see that the fund manager believes in the strong-from of the efficient market hypothesis. The prospectus states that this fund has a turnover ratio of just 4% and is 80% weighted in stocks, 20% which are diversified internationally. What I really like about this fund is the expense ratio of just .12% and no front-end or back-end loads.”
Do you know what you just read? What does turnover ratio mean? What is a load? Why is it important what form of the efficient market hypothesis the fund manager believes in? And by the way, what is a prospectus?
If you’re confused about a definition or two from above, don’t be concerned, a lot of investors are. That’s why I’ve compiled a list of 11 definitions that I find most investors don’t but should understand.
# 1 – Emergency Fund
What is it? – A minimum of three months, or more depending on your situation, of living expenses, set aside in a cash account.
Why is it important? – Once you start investing, you never want to withdraw upon your portfolio for emergencies. An emergency fund acts as a buffer between your investments and day-to-day living expenses. Therefore, before starting to invest, you should have an emergency fund.
To learn more about emergency funds here are a few helpful links:
- Building an Adequate Emergency Fund
- Two Hidden Benefits of a Large Emergency Fund
- Emergency Fund Investments
# 2 – Efficient Market Hypothesis
What is it? - An investment theory that states it’s impossible to beat the market because prices already incorporate all relevant information.
Why is it important? – The Efficient Market Hypothesis isn’t perfect, due to the fact that a small handful of people have out gained the market, but it’s still important for individual investors to understand.
What’s important to realize is that the people who have outperformed the market, like Warren Buffet, devote their life to finding undervalued stocks. For the rest of us, who don’t want to become professional traders, we’re better off not trying to beat the market, and simply accepting the returns the market provides.
Even Buffett himself said, “I believe in extreme diversification. I believe that 98 or 99 percent, maybe more than 99 percent, of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all, that is the way they should approach it.”
To learn more about Efficient Market Hypothesis here are a few helpful links:
- Efficient Market Hypothesis: Strong, Semi-Strong, and Weak via The Oblivious Investor
- The Efficient Market Hypothesis – Are You a Believer? via Darwin’s Money
# 3 – Asset Allocation
What is it? - The decision among what type of asset classes (such as stocks, bonds, real estate, gold, and cash) and the percentage each asset class (such as my portfolio will be 60% stocks and 40% bonds) make up of your portfolio.
Why is important? – No decision will have a greater impact on your return than asset allocation. One such study estimated that over 90% of your returns, is based off of what asset classes you invest in.
To learn more about Asset Allocation here are a few helpful links:
- Asset Allocation via Wikipedia
- All About Asset Allocation Strategy
- What’s the Best Way to Invest your Roth IRA
# 4 – Diversification
What is it? - After choosing your asset allocation, the next step is to decide what to own inside of each asset class. The process of selecting assets within an individual asset class is known as diversification.
Why is it important? – With over forty years until retirement, you decide that you have the risk tolerance to handle a 100% allocation to stocks in your Roth IRA. Looking at your option, you decide to put everything into Apple stock. After all, Apple’s a sure thing, right?
Two years go by and Apple has outperformed the stock market, by 5%. Your decision is looking good. However, all of a sudden, you start hearing rumors that Steve Jobs doesn’t have much longer to live. In 48 hours, your Apple stock is down 4%. Three days go by and Steve Jobs is pronounced dead. Apple stock drops another 8%. Now you’re trailing the market by 7% over two years.
Three years later, lacking the vision from Steve Jobs, Apple now trails the market by 22%. Your decision to allocate 100% of portfolio into stocks wasn’t why your portfolio is down. Your portfolio is down to due lack of diversification in stocks.
To learn more about Diversification here are a few helpful links:
- What you Need to Know about Portfolio Diversification
- What’s the Purpose of Diversification via The Oblivious Investor
# 5 – Asset Location
What is it? – The decision as to which type of account (Roth IRA, IRA, 401(k), taxable account, etc…) to invest in.
Why is it important? - The goal of investing isn’t just to earn the highest return possible. The goal is to maximize your return after-taxes and expenses. The decision as to what type of account you invest in makes a big difference in what your returns, taxes, and fees will be.
For example, instead of investing in a Roth IRA you decide to invest in a regular taxable account because of the increase in flexibility. If you save $5,000 a year from the age of 22 to 70 and earn 10%, in a taxable account you’ll accumulate $2,234,674 assuming a marginal tax rate of 25%. If instead you invested in a Roth IRA, you would have accumulated $5,280,948. The over $3,000,000 disparity between the two accounts is due to the taxes that you pay each year.
To learn more about Asset Location here are a few helpful links:
- Invest in a Roth 401(k) or IRA
- Asset Location: The Secret to Invest Success (Needs updating but still worth a look)
# 6 – Indexing
What is it? - An investment strategy that matches the overall market.
Why is it important? - If you combined the average returns of every investor over an entire year, it can only return what the market returns minus investment expenses. For example, if the market returns 10% after expenses, half of the investors will earn above 10% and half below 10%. Therefore, if your investments match the market but you incur lower costs than the average investor, you’re now in the top 50% of investors. And this is how even with average returns, you can out gain others.
To learn more about Indexing here are a few helpful links:
- Indexing via The Bogleheads Wiki
- Index Funds: The 12 Step Program for Active Investors via IFA
# 7 – Fund Load
What is it? – A front-end or back-end sales charge on each mutual fund share purchased. For example, if you invested $1,000 in a mutual fund with a 5% front-end load, only $950 will be invested. In contract, a back-end load is charged when you redeem your mutual fund shares. For example, you want to withdraw $950 in a mutual fund with a 5% back-end load. In order to withdraw the $950, you would have to take out $1,000. Luckily, there is such a thing called no-load funds. No-load funds do not have sales charges at the time of purchase or redemption.
Why is it important? – Say you started a Roth IRA at the age of 22. Your goal is to invest $5,000 a year into your Roth IRA at a 10% return until you’re 70. If you successfully invest $5,000 a year into a no-load fund with a 10% return, you’ll accumulate $5,280,948 at the age of 70. If instead you invest in a fund with a front-end load of 5%, and therefore are only able to invest $4,750 a year into a Roth IRA, you’ll accumulate $5,016,900. A difference of $264,048!
To learn more about loads here are a few helpful links:
# 8 – Fund Expense Ratio
What is it? – Expenses that you pay to an investment company to invest in their mutual fund. The expenses are taken out of the fund’s assets, which lower your returns.
Why is it important? – You can’t control how the market performs, but you can control your expenses. Here’s a great example to show how much costs matter–you have a choice between a mutual fund with a 1% expense ratio and a .2% expense ratio, a difference of just .8%, for your Roth IRA. If you invested $5,000 per year, from the age of 22 to 70, and earned 10%, you’ll accumulate $5,280,948. If instead you chose to invest in the mutual fund with a 1% expense ratio and therefore only earn 9.2%, you’’ accumulate $3,996,592. The .8% difference cost you $1,284,000!
To learn more about expense ratios here are a few helpful links:
# 9 – Fund Turnover Ratio
What is it? - The percentage of your fund’s assets that turnover each year. For example, a fund with a turnover ratio of 40%, kept only 60% of its assets.
Why is it important? – Each time your fund makes a trade, it incurs an expense. This expense comes in the form of trading expense, spreads, and taxes. These costs are passed down to you, the shareholder. Therefore, the higher the turnover ratio, the higher the expenses. And as you just found out, costs matter.
To learn more about turnover ratios here are a few helpful links:
- How Portfolio Turnover Effects Mutual Fund Returns via The Obvious Investor
- Turnover and Cash Reserves via Fool.com
# 10 – Fund Prospectus
What is it? - A document that contains important information about your fund. In the prospectus you’ll find, the fund’s objectives, strategies for achieving its objectives, what expenses and fees you will incur, past performance of the fund, and more important information. It’s not until after you invest in a fund, that a prospectus is sent to you. However, you can find your fund’s prospectus online. Therefore, before making an investment in a fund, read its prospectus.
Why is it important? - Any important information about your fund can be found in the prospectus. Read it!
To learn more about prospectuses here are a few helpful links:
- How to Read a Mutual Fund Prospectus via Get Rich Slowly
- How to Read a Mutual Fund Prospectus via Kiplinger
# 11 – Rebalancing
What is it? – The process of returning your portfolio back to its targeted asset allocation. For example, your original asset allocation was 80% in stocks and 20% in bonds. After one year, your stocks increased and your bonds decreased. Now instead of your desired asset allocation of 80/20, your portfolio is 95% stocks and 5% bonds. Unfortunately, this portfolio is too risky for you. Therefore, you sell some of your stocks and buy more bonds to return to an 80/20 allocation, and thus, rebalance your portfolio.
What is it important? - A rebalancing strategy, that’s consistently implemented, has proven to increase return, while decreasing risk. The reward is small, but as you saw, just .8% makes a huge difference in long-term returns.
To learn more about rebalancing here are a few helpful links:
- How to Rebalance Your 401(k) and Other Investment Portfolios
- Case Studies in Rebalancing via The Efficient Fronteir
In the comments, please discuss other investment terms that confuse you or are known to confuse others.