Glossary

Asset Allocation

Asset Allocation is how you spread all of your investment money between various asset classes. In most portfolios, the main 2 asset classes are stocks and bonds. When you invest in a bond you are loaning money to a government entity or a corporation. When you invest in a stock you are buying a small share in a corporation. For more go to Asset Allocation.

Average Annual Return

This is the arithmetic mean of a string of annual returns. For example, consider these five years of returns: 5%, -9%, 3%, 8%, 12%. The Average Annual Return is the average of these five numbers: 19/5=3.80%/year. This measure loses accuracy and usefulness as the year-to-year variations grow. Regardless, investment companies routinely publish 1, 3, and 5-year Average Annual Returns is the most available number investors can use to compare funds. 

Before you do any detailed comparisons, be sure to understand what's included in the numbers. Some Average Annual Returns include reinvested distributions but ignore operating expenses, sales charges, and inflation. The term "Total" is sometimes included in the term to indicate the inclusion of some or all of these items. So be sure you're comparing "apples and apples."

Also, see the definition of "Compound Annual Growth Rate" (below).

Blogs (Posts, RSS, and email feeds)

Blogs are a page or two of content that an author writes for publication to their subscribers, and also that are stored on their website. Posts are new pages that someone like me puts on their website, and then sends out a notification letting my subscribers know the new content is available. "Feeds" refers to the notifications themselves, blogs or posts. My feeds come in two varieties: RSS and email. For more on this, check out About Subscribing.

Bonds

When you buy a bond you are loaning money for a time period to a company or government entity that promises to pay you a regular dividend (interest) for the use of your money. When the time period on the bond ends they promise to repay you the original amount of the loan. To get your money sooner, you can usually sell your bond on a secondary market - but probably not for the original loan value. Several factors affect the secondary market's valuation of your bond; an important one is the prevailing interest rates. For more on this see "duration."

An “investment grade” bond is a loan to a corporation (not a government entity) that has a good credit rating.

A “high yield” bond is a loan to a corporation with a lower credit rating. While it will pay a higher dividend, there is more risk of default. These are often called, “junk bonds.”

The bond market is complex. For more, read Bobbleheads’ Bond Basics. For more on the impact of interest rates, read Boggleheads’ section on Duration.

Capital gains

Capital gain is the difference between your "cost basis" (see below) and your net selling price. Current law (3/2013) classifies a capital gain as long-term if you held the stock longer than 1 year. Long-term capital gains have historically had a lower tax rate than earned income - today (2016) their tax rate is zero for modest marginal tax rates. If you held the investment 1 year or less it is called a short-term capital gain; this has historically been taxed at the same rate as earned income.

Capital gain distributions

If you own a mutual fund, the capital gain distribution is the realized gain on shares that the fund manager sold in the year. These are taxed in the year the fund sold the shares. Depending on if the fund held the shares for more than one year or not, these are taxed at the long-term capital gain rate or at the higher rate of earned income. An index fund tends to trade stocks much less often than an actively managed fund, so the capital gains distribution for an index fund is generally lower - resulting in index funds generally being a little more tax-efficient than actively managed funds. Vanguard's analysis is that the actively traded funds cost the owner about 0.45%/year more in taxes than the same gain in an index fund.

Compound Annual Growth Rate (CAGR)

This is the geometric mean of a string of annual returns and a better way to calculate the returns of any investment. For example, consider the same five-year example that we used in the definition of Average Annual Return (above): 5%, -9%, 3%, 8%, 12%. To find the CAGR, multiply each year's return together, and then take the nth root of the result. Like this: 1.05*0.91*1.03*1.08*1.12 = 1.190, meaning in five years, the investment grew to 1.190 times the initial amount, which is a cumulative growth of 19%. To turn this result into the CAGR, use a calculator (or the address bar of any browser) to take the 5th root of 1.190. Like this: (1.190)0.2 = 1.0354. So the CAGR of our example is 3.54%/year. 

Notice that this CAGR is lower than the Average Annual Return for the same data (see above definition for Average Annual Return). The CAGR is more accurate, and will always be lower. 

Note that the CAGR generally includes reinvested distributions, but ignores expenses, sales charges, and inflation.

For more: Investopedia post: The Most Accurate Way to Gauge Returns (CAGR). Also, see the definition of Internal Rate of Return (lower on this page). 

Correlation (and autocorrelation)

Correlation measures the tendency of one investment with another. A correlation factor of 1 indicates that when investment A goes up 20% you can expect investment B to also go up 10%. A correlation factor of -1 indicates that when A goes up some amount, B goes down that same amount. And a correlation factor of 0 indicates no correlation at all. 

Autocorrelation measures the correlation of an investment's value in one timeframe with that same investment in another timeframe.  

For more on correlation and autocorrelation, see Investopedia.

Cost basis

This is the original cost of an investment, plus an adjustment for whatever the investment may have paid you along the way. When you sell the stock you will need to pay the tax on the difference between the cost basis and the net selling price. The investment institution that holds your investments keeps track of the cost basis for you and reports it on Form 1099.

Dividends

Dividends are payments your investments make to you along the way. Bonds generally pay non-qualified dividends which are taxed as ordinary income. Stocks sometimes pay qualified dividends, which are taxed at a lower capital gains rate. For more see Ehow Money Qualified vs. Non-Qualified Dividends. Dividends are an important component of a stock's return: since 1926 dividends have accounted for about 40% of the stock market's annualized total return (which was about 10% before inflation).

Duration

Duration is a measure of the volatility of a bond's market value when interest rates change.

If you buy a bond paying a "coupon" rate of 5% of face value per year and later the interest rates in the country increase 1%, to sell it on a secondary market you must lower its price until it's competitive with a current bond. But how much? The answer to that question is buried in the bond's "duration," which is measured in years. A bond with a duration of 5 years means that if interest rates increase 1% then the market value of your bond decreases by 5%. Conversely, if interest rates fall the underlying value of your bond increases. Here's the equation: (bond price change) = -1 * (duration) * (interest rate change).

Another helpful way to understand duration is that it is the break-even point resulting from reinvesting the bond's interest payments at the new coupon rate. So if interest rates increase 1% and your bond's market value decreases 5%, then each reinvested dividend buys more bond shares than it did before the change. In 5 years you'll be back at the net asset value of your bond. So if your time horizon for the bond investment is longer than the duration, you want interest rates to rise. Otherwise, not.

Efficient Frontier

This is the most esoteric term I use on this website. But I thought it important enough to devote a whole web page to it: Efficient Frontier.

Effective Tax Rate

This is the average tax rate. For an individual, this is the total tax paid (line 63 on the 1040 tax form) divided by the taxable income (line 63). (see also Marginal Tax Rate)

Gordon Equation

Expected Return = Current Dividend + Dividend Growth Rate. This is the expected "real return," meaning it is inflation-adjusted. The nominal Dividend Growth Rate for U.S. stocks is 1.32%. So if the dividend rate of the S&P 500 is 2.5%, then the real expected return of the S&P 500 is 3.82%. The Gordon Equation applies to mature company stocks that pay regular dividends and groups of stocks such as those on the S&P 500 Index. It also applies to markets around the world, albeit with a different Dividend Growth Rate. This concept comes from a paper by Myron Gordon, Toronto University, 1959. For more on this see William Bernstein's book: The Investor's Manifesto - Preparing for Prosperity, Armageddon, and Everything in Between (especially see chapter 2). Here's another web page that offers a pretty simple explanation: Dividend Discount Model Overview (from the Dividend Monk).

The Gordon Equation does not apply to bonds.

Index Funds

Index funds are mutual funds that contain the same stocks that are the basis for the published indexes, such as the S&P 500. By contrast, managed funds are mutual funds where a professional team buys and sells stocks in an attempt to beat the index. 

Index funds have 3 distinctions that are worth remembering:

1. Lower management fees, because they don't need as much research.

2. Lower brokerage expenses, because the stocks in the index don't change nearly as often as the stocks in a managed fund.

3. They generate less taxable income every year, again because their stocks don't change as often.

Managed funds seldom beat their target index by enough to cover these 3 inherent advantages of index funds.

Internal Rate of Return (IRR)

While investment companies publish their data as Average Annual Returns and sometimes as Compound Annual Growth Rates, these are not useful measures for an investor's actual portfolio. The reason: after making our initial investment because we add more money to that investment or withdraw money from it. And the timing and market price of our shares when we add or withdraw significantly impacts the underlying compound rate of return of our portfolio. The Internal Rate of Return is the mathematical way to compute the underlying performance of our portfolio. It is the best number we can come up with to compare with the CAGR of our benchmark.

IRR math is too complex for the average investor. Fortunately, there are some tools available to do it for us, but even they take some work to implement. One such tool that I use is Quicken (Premier). It aggregates my investments across multiple investment companies, tracks all my buy/sell instances, and then computes the IRR. This computation inherently includes expenses, fees, and sales charges - so to that extent, my IRR will always differ from the CAGR of my benchmark. 

Also, some investment company websites (such as Vanguard) offer tools where you can manually insert investments held in other companies. But it is impossible for Quicken, or any aggregating company, to access enough data about your other investments to include these in your IRR. So, unless you use Quicken as your aggregator, the best you can do is use the IRR computational capability in all your investment companies and manually aggregate them. 

Without using Quicken or manually aggregating the IRRs from multiple companies, you cannot know if your actual returns are any better than you could have had from just buying a single balanced mutual fund - and they might be worse! 

For more on this, see Portfolio Evaluation and Investor Returns versus Fund Returns.

Marginal Tax Rate

This is the tax you will owe on the next dollar of ordinary income. In the U.S. the rate of taxation rises for higher-income people. There are 7 different marginal tax brackets. For individuals, the tax is 10% in the lowest bracket up to 39.6% in the highest bracket, which is for income above $415,050. For a detailed explanation, see Investopedia: "Marginal Tax Rate."     

Real Return

Whenever you see "real" associated with return or interest rate it means this number is modified to account for inflation. So if you receive 3% dividend on a bond but the inflation rate is 2%, your "real return" is only 1%. Note that this is before taxes.

Required Minimum Distribution (RMD)

RMD is the amount that traditional "tax-free" retirement owners must begin receiving annually from their retirement accounts when they reach age 70.5. It is calculated each year as a function of how much remains in our retirement account and our remaining life expectancy. It does not apply to Roth's.

This is how the government eventually recovers taxes on the "tax-free retirement contributions" they've allowed us to make over the years, as well as on their dividends and capital gains. But in the case of the RMD, all these are taxed at the earned income rate (even the long-term gains).

Risk (standard deviation)

Risk is a measure of the volatility of an investment. Finance people use the mathematical concept of "standard deviation" to quantify volatility. A high standard deviation means the investment's market value varies a lot during the time you hold the investment. It means the same thing as volatility. That's about all you need to know to read my Personal Finance web pages. The math is complicated, to learn more read this Wikopedia page. 

Stocks

When you buy a stock you are purchasing a share in a company. are ownership of some shares in a company. The value of the stock changes as the company's business changes and as the entire market changes. The stock may pay a dividend, meaning that it pays some of its profits to its shareholders instead of reinvesting them all back into the company. 

Stocks of companies are classified in various ways, such as by size (large-cap, mid-cap, small-cap) and by type (value, growth), and geography (domestic, international, emerging market). 

For example, small-cap is short for small-capitalization.  These are shares in small companies where the total value of the company is between $300M and $2B.  This is the amount you would have to pay to go onto the stock market and purchase all the shares of a company's stock. To compute a company's "market capitalization" you multiply the number of outstanding shares (available on the company's annual report) times the current price of one share. 

In marketing literature, you will also see mid-cap and large-cap stocks. However, the correlation between these two sectors is close enough together that many investors (including me) just consider these all large-cap.

Value stocks are companies where the stock price is low compared to some fundamental measures. For example, such companies generally have a lower earnings-per-share ratio than the stock exchange as a whole. Or they have a lower price-to-book ratio or are expected to pay increasing dividends over the near few years. These can be small, mid, or large-cap.

Total return

This is the total income and capital appreciation of an investment over some specified time. For example, if you read that a fund's 3-year total return is 9%,  it means the return for the entire 3 years is 9%.  (NOT 9%/year). But when you read that a company's 3-year average annual return is 9%, it means the return is 9%/year.

All the best,

Tim Isbell