Foundations: Definitions part 1
All kinds of terms are thrown around when talking about money and saving and investing, but they’re not always super clear. Like equity or security or stock – what the heck is the difference? If you find yourself scratching your head or fumbling through explanations of the financial news, you are not alone.
Here is a short list of common financial terms and definitions to help out. (For words with several meanings, I am only including definitions relative to finance.)
Investment – An investment is a monetary asset purchased with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit.
Equity – Equity is the amount of money that would be returned to an owner if all relevant assets were liquidated and all debt was paid off. A common example is home ownership: the home owner’s equity = current value of the house – amount still owed. As home prices rise and/or debt gets paid off, an owner’s equity increases.
Securities – A security is a negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation (stocks), a creditor relationship with a governmental body or a corporation (bonds), or rights to ownership (options).
Market price – Market price represents what an owner could expect to collect should an asset be sold immediately. As with home values or the exchange rate of the US dollar, market values for assets change all the time based on a large number of factors beyond the control of the owner.
Cash – For our purposes, the word ‘cash’ means ‘cash and equivalents’ – all assets that are cash or can be converted into cash immediately. This includes checking and savings accounts, money market accounts, Treasury bills and government bonds with maturities of three months or less, along a few other less common things.
Stock – A stock is a type of security that signifies proportionate ownership in the issuing corporation. This entitles the stockholder to that proportion of the corporation's assets and earnings (if any). Companies issue shares of stock to raise money for business activities. Since owning shares of stock represents owning a small part of a company, they are considered equities.
Bond – A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically a corporation or government). Governments and companies sell bonds to raise money for business activities. When you buy bonds, you are effectively lending a government or company your money in exchange for promised interest payments and return of principal at some later date.
With few exceptions, bonds are commonly issued with face value (also called par value), which represents the amount the issuer is obligated to repay the bond holder; maturity, which represents the date that the debt must be repaid; and coupon rate (or interest rate), which represents the amount that bond holders earn in exchange for lending money.
Asset Allocation – Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to goals, risk tolerance, and investment horizon. The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.
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