Glossary | The Only Three Questions That Count

Accretive - Anything making a firm's value grow, particularly as reflected in earnings-per-share.

American Depository Receipt (ADR) - Receipt for a foreign firm's share, paid for in American dollars and traded on American exchanges. Americans trading in ADRs needn't exchange dollars for foreign currency.

Annualized Average (or, Geometric Average or Mean) - Rather than an arithmetic average (or mean), an annualized average properly calculates annual investment returns. To get an annualized average, multiply 1 plus each year's return, raise it to the power of the nth root (where n is the number of years), and subtract 1.

Ask - Also known as the offer, the ask is the price a seller is willing to accept for a security. The difference between the bid and ask is known as the bid-ask spread. See also bid.

Bear market - A prolonged broad market downturn exceeding 20 percent. Not to be confused with a correction. Investors are bearish if they are fearful of stocks. Some investors are perma-bears, generally always preferring lower returns with less volatility.

Bear - An investor who is pessimistic about future returns—usually regarding stocks—but the term can be applied to any investing category.

Beta - A measure of a stock's (or category's) volatility relative to an index. For example, if the S&P 500's beta is 1, stocks with higher beta are more volatile, and stocks with lower beta are less volatile, than the broad market. Beta can also be used to measure relative volatility among peers.

Bid - The price a buyer offers to pay for a stock. See also Ask.

Bid-Ask spread - The difference between the bid and the ask.

Blue chip - A large, nationally recognized, financially sound firm with a long track record usually selling high-quality and widely accepted goods and services. General Electric, ExxonMobil, and IBM are all considered blue chips.

Bond - A debt investment. Investors lend money to an institution by buying bonds and receive fixed interest payments in return. When the bond matures, the investor receives the principal back. Municipal bonds (munis) are exempt from federal taxes and some state and local taxes if you live in the municipality where the bond is issued. U.S. Treasuries are exempt from state taxes.

Bond fund - A mutual fund in which the underlying investments are largely bonds.

Bubble - Frequently misused in reference to any category's price that has appreciated—true bubbles are rare. A bubble, normally identified after it has burst, is the rapid increase and subsequent decrease in prices for a specific category of equity or commodity (e.g., tech in 2000; energy in 1980).

Bull market - A lengthy period of time marked by overall positive broad market returns. Bull markets have occupied over 70 percent of historic periods.

Call option - The right to buy a stock (or bond or commodity) at a certain price by a certain date. A call option writer sells the right to a buyer.

Capital gain - Appreciation in value of a security, bond, commodity, or other instrument.

Capital gains tax - Tax paid on any capital gain when it's realized (sold).

Carry trade - When an investor borrows in one currency at a lower interest rate and buys a short-term bond at a higher interest rate in a different currency. As long as the higher yielding currency doesn't weaken, the spread between the interest rates is profit.

Cash flow - For investors, any cash generated by dividends, interest, coupon payments, or proceeds from the sale of stocks, bonds, or commodities. On a tax - adjusted basis, no form of cash flow is superior to any other.

Central bank - The institution in each country responsible for setting monetary policy, printing money, managing reserves, and controlling inflation. In the U.S., the central bank is the Federal Reserve System, also known as the Fed.

Certificate of deposit (CD) - Debt instrument issued by a bank paying a fixed interest rate driven by market forces. Investors commit to a fixed period in return for a fixed interest rate. Maturities range from a few weeks to a few years.

Cognitive bias - In behavioral finance, the tendency to believe something is true that is not supported by facts but by tradition or conditioning.

Commodity - Goods traded on a commodity market in bulk, such as metals, grains, and food. Other investment vehicles may be traded on a commodity exchange, such as certain futures and options.

Confirmation bias - Cognitive error causing investors to seek evidence confirming their preset notions and reject contradictory evidence.

Consumer Price Index (CPI) - Issued by the Bureau of Labor Statistics (BLS), this figure is a popularly used measure of inflation. It measures the relative change in prices of a basket of consumer goods and services.

Contrarian - An investor who believes the likeliest outcome is the opposite of what the consensus expects.

Correction - A short, sharp downturn in prices during a longer bull market trend, usually marked by investor pessimism and a bearish story that is later deemed a nonevent. Corrections are of a lesser magnitude and lesser duration than bear markets. Bear markets have short, sharp positive corrections.

Correlation - A statistical measure between -1 and 1 demonstrating similarity between two variables’ movements. A correlation close to 1 means the two variables move in a similar direction and magnitude. A correlation close to -1 means the two move in opposing directions. A correlation close to 0 means the two have no similarity.

Covered call - A covered call combines a "written" call option with a long stock position. Loss potential is total except for the premium, making a covered call the exact same security as a naked put.

Cyclical stock - A stock sensitive to business cycles moving largely with the market. A stock for which there is elastic demand.

Day trading - Trading with the intention of capturing short-term moves. Day-traders may buy and sell the same security within a few hours, weeks, or months.

Debt-to-equity ratio - Ratio demonstrating an institution's debt relative to its equity. Just one component used by corporations in assessing optimal capital structures. Also, used by lending institutions to determine the amount they are willing to lend an individual or corporation.

Defensive - Describing anything that counteracts big market downside. A defensive portfolio is one intended to be up slightly or flat during a bear market.

Defensive stock - A stock viewed as typically stable during economic downturns and capable of weathering bear markets well. A stock for which there is inelastic demand.

Deflation - A drop in average price levels, usually caused by excessive tightening of money supply. Can lead to reduced economic demand and higher unemployment. Not to be confused with disinflation.

Dilutive - Anything reducing the value of a firm, particularly as reflected in earnings per share.

Discount rate - The rate charged member banks for borrowing directly from the Federal Reserve Bank. This rate is controlled directly by the Fed.

Disinflation - The slowing of growth of average prices levels. Can be thought of as the slowing of inflation. Not to be confused with deflation.

Dividend - A taxable payment made to stock holders, usually quarterly, out of a firm's current or retained earnings. Can be paid in cash or stock.

Dow Jones Industrial Average (DJIA) - A price-weighted index of 30 blue chip U.S. stocks. Commonly referred to as the "Dow."

Earnings per share (EPS) - A firm's total earnings divided by total number of shares outstanding.

Earnings-to-price ratio (E/P) - Ratio of a firm's earnings per share to its share price—also known as the earnings yield. The reverse of the price-to-earnings ratio (P/E).

Earnings yield - This valuation, expressed as an interest rate, easily allows a comparison between the relative value of stocks and the going bond rates as well as borrowing costs. See also earnings-to-price ratio.

Efficient market - The theory that the stock market quickly and efficiently prices in all widely known information, which is why trading on known information will not yield excess returns.

Elastic demand - Demand for goods and services that is sensitive to economic cycles and expands and contracts with the economy. For example, demand for high-priced technology or consumer discretionary goods is generally elastic.

Excess return - Return garnered above a stated index's return.

Exchange-traded fund (ETF) - A security that tracks a specific index, equity category, or other basket of assets but is traded on an exchange like a single stock.

Expense ratio - Usually expressed as a percentage, the amount of total fund assets used to cover all expenses of managing the fund. This includes the management fee clients pay as well as trading, taxes, and other operational expenses. The expense ratio lowers the total return for the investor.

Federal funds rate - The rate banks charge each other for borrowing federal funds. This rate is also controlled by the Fed.

Federal Open Market Committee (FOMC) - A 12-member committee responsible for setting credit and interest rate policy for the Federal Reserve System. They set the discount rate directly and control the federal funds rate by buying and selling government securities impacting the rate. They meet eight times a year under the direction of a chairman—currently Ben Bernanke.

Federal Reserve Board - The seven members of the Board of Governors are appointed by U.S. presidents to serve 14-year terms. They serve on the FOMC and assist in setting monetary policy.

Federal Reserve System - The U.S. central banking system, responsible for regulating the flow of money and credit. Known as the Fed, it serves as a bank for other banks and the U.S. government.

Front-running - Trading based on soon-to-be public information, hoping to get a short-term run-up in price when the news disperses. An example of insider trading and a felony.

Fundamental analysis - A method of stock analysis focusing solely on a firm's fundamentals—financials, debt, management, operations, competition, and the like—in determining the future value of a stock.

Glass-Steagall Act - A series of laws passed in response to the stock market crash of 1929 sponsored by Senator Carter Glass (D-VA) and Henry B. Steagall (D-AL). Among other reforms, the act capped interest paid on savings deposits, established the Federal Deposit Insurance Corporation (FDIC), which insures deposits in the event of bank failure, and most notoriously separated the banking and brokerage industries—prohibiting banks from offering investment, commercial banking, and insurance services. President Clinton signed the Gramm-Leach-Bliley Act repealing the Glass-Steagal Act in 1999.

Gold standard - A monetary system pegging the value of currency to a fixed weight in gold. An international gold standard was established via the Bretton Woods Agreements in 1944. The U.S. abandoned the gold standard and the Bretton Woods Agreements fell apart in 1971.

Gramm-Leach-Bliley Act - In response to the mega-merger of Citibank (a traditional bank) with Travelers Group (an insurance firm), this act was passed in 1999 to modernize financial services laws. Most important, it repealed the Depression Era Glass-Steagall Act by allowing competition among banks, securities firms, and insurance firms, creating the all-encompassing "financial" sector.

Gross domestic product (GDP) - The monetary value of all goods and services produced in a country over a certain time period. In America, the U.S. GDP’s growth is a popularly used indicator of overall economic health.

Growth stock - Any stock with a P/E higher than the broad market's average. Because growth stocks have high P/Es (an after-tax measurement), they also have low E/Ps (i.e., the earnings yield, or the reverse of the P/E) and a relatively low cost of raising capital through stock issuance.

Hedge fund - A managed portfolio of investments that is generally unregulated (unlike a mutual fund or a registered investment advisor) and may invest in any highly speculative or illiquid vehicles, including options. The underlying investments can be illiquid, but so can the fund as some hedge funds require a minimum investment period.

Hindsight bias - A cognitive error causing investors to exaggerate the quality of their foresight—overestimating quality of initial knowledge and forgetting initial errors.

Hyperinflation - The rapid increase in average price levels, usually caused by excessive money supply growth.

Illiquid - Anything not converted quickly into cash.

Index fund - A mutual fund tracking a stated market index.

Individual retirement account (IRA) - A retirement account any employed person (or spouse of an employed person) can open and contribute to. Assets in the account grow tax deferred and contributions may be tax deductible, depending on the account holder's adjusted gross income. Distributions taken before age 59-1/2 are generally subject to penalty. Distributions taken after 59-1/2 are taxed at the account owner’s income tax bracket.

Inelastic demand - Demand for goods and services that is constant, no matter the state of the economy. For example, demand for pharmaceuticals and some consumer staples is generally inelastic, as consumers usually won't buy more or less in an economic expansion or contraction.

Inflation - Rate of increase in average price levels. Different indexes use different baskets of goods and services to compute the average prices. A commonly cited index is the Consumer Price Index (CPI).

Initial public offering (IPO) - The first sale of equities to the public by a private firm. In making an IPO, a private firm has "gone public."

Insider - Any person with access to nonpublic information material to a firm, which can include officers, directors, and other key employees as well as their immediate families. Insiders are strictly prohibited from trading based on inside information.

Insider trading - Trading based on any nonpublic information—which is a felony. One need not be an insider to commit insider trading.

Margin - borrowed using securities as collateral.

Market capitalization (market cap) - Value of a company as measured by the total value of outstanding shares (current share price times total number of outstanding shares).

Market index - A representation of the weighted average of companies comprising an index. The index is intended to represent a category, country, or the market as a whole (e.g., S&P 500, TOPIX, or Nasdaq).

Momentum investing - A trading strategy trying to capture short-term price movements based on the belief that stock price patterns are indicative of future results.

Monetary policy - Actions by a country's central bank impacting money supply and growth, credit conditions, and interest rates.

Mutual fund - An investment company investing in a variety of securities as dictated by the specific fund's prospectus. Investors do not own the underlying investments; they buy shares of the fund itself.

Myopic loss aversion (sometimes just loss aversion) - A cognitive error causing investors to act to avoid short-term loss, usually at the detriment of longer-term goals.

Naked put - A put option in which the seller (or "writer") does not own the short position. Loss potential is total except for the premium. The exact same security as a covered call.

Nasdaq-100 Index - A modified capitalization-weighted index designed to track the performance of the 100 largest and most actively traded non-financial domestic and international securities listed on the NASDAQ Stock Market.

Nasdaq Composite Index (or just "the Nasdaq") - A capitalization-weighted index designed to track the performance of all the securities listed on the NASDAQ Stock Market. Though most listed companies are technology related, the Nasdaq includes financial, bio-tech, industrial, and consumer companies.

The NASDAQ Stock Market - The National Association of Securities Dealers Automated Quotations System (NASDAQ) Stock Market is a fully electronic stock market. Listed companies include domestic and international firms in the financial, bio-tech, industrial, consumer, and technology sectors.

No-load fund - A mutual fund that does not charge an upfront commission. However, some no-load mutual funds still charge 12b-1 fees.

NYSE Composite Index - A capitalization-weighted index designed to track the performance of all common stocks listed on the New York Stock Exchange (NYSE).

Opportunity cost - Risk of missing superior returns from an alternate investment.

Order preference - A cognitive error causing investors to insist on certain things in a certain order for no other reason than societal convention. For example, order preference causes professionals to make annual forecasts in January, not April. It also causes investors to focus on individual stock or category performance rather than their whole portfolio.

Overconfidence - A cognitive error causing investors to overestimate their skill or knowledge. This may lead investors to trade too frequently, day-trade, or become overweighted in a presumed "hot" category.

Positive yield curve - A yield curve in which shorter-term rates are lower than longer-term rates. A positive yield curve occurs most of the time, and signals favorable credit conditions.

Price-to-earnings ratio (P/E ratio) - A ratio of a firm's share price to its earnings per share. One of the most commonly cited stock valuation ratios.

Price-to-sales ratio (PSR) - Ratio of a firm's share price to its per-share sales.

Pride - Mental process associating success with skill and repeatability.

Prospectus - A legal document accompanying a mutual fund or an annuity detailing the investment objectives, manager history, expenses, fees, and other investment details.

Put option - The right to sell a stock (or bond or commodity) at a certain price by a certain date. A put option writer sells the right to a buyer. If the option exercises, the buyer puts the stock to the writer, and the writer must buy it.

Random walk - The theory that stock prices follow a random, unpredictable path, and past price movements are not predictive of future movements.

Recession - A contraction in the business cycle, usually manifesting in slow or negative GDP growth.

Regression analysis - In statistics, a method for measuring the relatedness of two variables.

Regret - Mental process denying responsibility for failure.

Return on assets (ROA) - Ratio of net income to total assets.

Return on equity (ROE) - Ratio of net income to equity (net worth).

Risk - Investors typically equate risk with near-term volatility. However, simply, risk is the price of being wrong about an investment.

Russell 2000 Index - A capitalization-weighted index designed to track the performance of the 2,000 smallest (on a market-capitalization basis) U.S. stocks included in the Russell 3000 Index.

Russell 3000 Index - A capitalization-weighted index designed to track the performance of the 3,000 largest (on a market-capitalization basis) and most liquid U.S. stocks.

S&P 500 Composite Stock Price Index - A capitalization-weighted index designed to track the performance of the 500 stocks of the S&P 500. Stocks are included in the index based on their liquidity, market-cap (i.e., "large" cap), and sector. While not necessarily the 500 largest U.S. companies, these are generally the 500 most widely held.

Sell short (or just short) - When an investor sells a borrowed security with the intention of buying it back at a lower price. The difference between the price where the investor borrowed and sold it and bought it back is profit. This can be done with an individual security or an index.

Short rate - Interest rate that is monopoly set by a country’s central bank. Not to be confused with a short-term rate.

Short-term rate - Free market-set interest rate of a shorter-term maturity (e.g., the interest rate on a 3-month T-bill is a short-term rate).

Small cap - Refers to the relative size of a firm's market capitalization. Traditionally, any firm with a market cap under $10 billion or $20 billion was referred to as small cap. However, a better guide is the dollar-weighted average of the broad market. Small caps are smaller than the dollar-weighted average.

Standard deviation - A measure of dispersion from the mean. In investing, standard deviation is used to measure volatility risk (e.g., a stock with a high standard deviation is understood to be very volatile).

Stop-loss (also, stop-limit) - An order placed with a broker to sell a stock when it reaches a certain price.

Supply-side economics - Championed by Art Laffer, Jude Wanniski, and Ronald Reagan (whose critics derisively called it "voodoo" economics), a theory of macroeconomics focusing on the supply side of the supply-demand equation—believing supply creates its own demand. Supply-siders believe, among other things, lowering income tax rates increases economic activity and therefore increases income tax receipts.

Tax deferral - Legally postponing the payment of taxes on gains through an investment vehicle such as an IRA, 401(k), or other retirement accounts.

Tax-loss selling - Selling stocks that are down at the end of the year to offset any taxable gains realized in the same year to reduce overall tax liability.

Tax-losses may also be carried forward to offset future taxable gains.

Technical analysis - Analysis of a stock's historical price movements using charts or other tools to detect patterns while disregarding stock or market fundamentals. This strategy is based on the belief that past performance is indicative of future performance.

Terminal value - The projected value of an asset at the end of an investor's time horizon.

Time horizon - The period of time an investor needs their assets to last. For most investors, their time horizon is their life expectancy or that of a spouse or beyond.

Total return - The true rate of return of an asset, including capital gains, dividends, interest, and distributions realized over a given period.

Treasury bill (T-bill) - A U.S. debt security in maturities of less than one year.

Treasury bond - A U.S. debt security in maturities from 10 to 30 years.

Treasury note - A U.S. debt security in maturities from one year to seven years.

12b-1 fee - Part of a mutual fund expense ratio that reimburses the fund for marketing, promotion, and distribution costs. Reduces the investor's total return.

Value stock - Any stock with a P/E lower than broad market's average. Because value stocks have low P/Es (an after-tax measurement), they also have high E/Ps (the reverse of the P/E and also the earnings yield). When borrowing costs are lower than their earnings yield, value companies will generally be more eager to raise expansion capital through borrowing rather than stock issuance.

Volatility - Generally thought to be a measure of market risk. Can be expressed as a statistical measure of the return variance between two securities, a security and the market, two equity categories, and so on. If something is more volatile, it has more return variance and is thought to be more risky.