Glossary

Investors are often left scratching their heads over seemingly impenetrable investment terminology. Please look here for plain-English definitions of commonly-encountered terms.

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Absolute Return

Amount, in dollars or percent, by which the value of an investment changed over a measurement period (a year, a quarter, etc.).

Absolute Risk

The risk of losing money.

Accredited Investor

A term defined by federal securities law to denote an investor permitted to invest in certain types of higher-risk investments, such as private equity limited partnership Currently, this definition includes individual investors holding investible assets of at least $1 million, or having income of at least $200,000 for the last two years (or $300,000 with a spouse) and the expectation of the same amount during the current year. General partners of limited partnerships that accept only accredited investors, and which limit the investor base to a maximum of 100 such investors, have historically been exempt from registration requirements with the Securities and Exchanges Commission. See Qualified Purchaser.

Active Management

Investing to try to beat a benchmark, by picking assets that the manager expects will outperform. Contrast with passive management.

Alpha

Difference in performance between an investment and its benchmark. Investors hire active managers in the hope of earning positive alpha.

Alternative Assets

Assets that are expected to have returns that are driven wholly or partly by factors other than market returns. For example, timberland is an alternative asset, and its return will be driven partly by how fast the trees grow. Hedge funds and private equity are the two major kinds of alternative assets.

Annualized Return

The return that, if earned consistently during the measurement period, would equate the starting value and the ending value. For example, an investor investing $1 million, who earns -20% in Year 1 and +50% in Year 2, will have an investment valued at $1.2 million at the end of Year 2. The same $1.2 million at the end of Year 2 would be earned by a return of 9.54% in each of the two years. 9.54% is therefore the annualized return for the two years.

Asset

Something owned. A house, a patent, a factory, or a checking account may all be assets. Assets that are held solely or primarily in order to earn a return (income or appreciation) are investments. Thus, an automobile owned for the purpose of providing personal transportation to its owner is an asset, while an automobile owned for the purpose of providing transportation to paying clients (e.g., a taxi) is an investment.

Asset Allocation

The division of an overall portfolio of assets into asset classes. Often confused with diversification. Every investor has an asset allocation, even if its 100% cash.

Asset Class

A group of assets that share basic characteristics and can be expected to respond similarly to given economic, political, etc., events and forces. For example, U.S. stocks are an asset class for which returns are driven by the combination of (1) dividend payments; (2) corporate profit and (3) the value investors are willing to pay for those profits (Price/Earnings ratio). They may generally be expected to do well when interest rates are low, the budget is balanced, corporate profits are good, and so on.

Balance Sheet

A financial statement that shoes what is owned (assets), what is owed to creditors (liabilities), and what is left over for owners (net worth or equity), as of a specific point in time, generally the end of a fiscal quarter or year.

Basis Point

1/100th of a percentage point. Used as a verbal shorthand by financial professionals. For example, rather than say “fees are 75 one-hundredths of a percentage point,” investment professionals say “fees are 75 basis points”.

Benchmark

In the investment context, a comparison group of similar managers or funds (for example, all managers of U.S. large capitalization stocks) or an index. Usually used as a reference point for the measurement of performance.

Beta

Fluctuation of one asset per unit of fluctuation of another asset (the base). For example, if a particular stock on average goes up or down 1.2 percentage points for every 1 percentage point the S&P 500 goes up or down, the stock is said to have a beta of 1.2 with respect to the S&P 500. The higher an asset’s beta, the greater its fluctuations, and therefore the riskier it is said to be.

Bond

A financial instrument that pays a set rate of interest (called a coupon) during its life and then pays back its face amount when it matures. For example, a 5% coupon ten-year bond will pay 5% of its face value in interest each year during its life, and it will pay back the original $10,000 at the end of the tenth year.

Bottom-up analysis

Analysis that begins at the “micro” level, by examining the fundamental characteristics of an issuer of a security, and then proceeds up through more macro levels of analysis, such as the issuer’s sector, industry, and geography. Contrast with top-down analysis.

Buyouts

Private equity investing that typically targets companies with existing businesses, often those with a need for turnaround management services. Such businesses have often been publicly traded, or been units within a publicly-traded company, before being purchased by a private equity investor.  Contrast with venture capital.

Cap rate

A measure of valuation in real estate transactions, calculated by dividing the purchase price of an asset by its annual net income or net cash flows. This is analogous to a Price / Earnings ratio for a traded stock. The higher the cap rate, the more expensive the price of the real estate.

For example, paying $1 million for a building that generates rental income of $100,000 per year implies a 10% cap rate.

Cap(italization)

(1) The value of all of a company’s shares outstanding times the price per share. For example, a company that had 1 million shares outstanding, with a price per share of $20, would have a capitalization of $20 million. Investment styles are often divided into “small cap”, “mid cap” and “large cap”, meaning the average size of the companies in the portfolio. Often referred to as “market cap[italization]”. (2) In discussing a company’s balance sheet, sometimes used to refer to the company’s overall sources of funding, including both debt and equity.

Carried interest

Another term for incentive fee. A fee charged by an investment manager based on the investment gains earned. A 20% carried interest is typical for alternative assets.

Cash flow statement

A financial statement that shows the movement of cash during an accounting period, as opposed to changes in accounting value. For example, depreciation is an accounting concept; it does not involve the movement of cash.

Correlation

In an investment context, the degree to which two assets move together. Correlation is expressed as a number between +1 and –1. Two assets that have a +1 correlation move together exactly—whenever one goes up 1%, so does the other. For example, one Class A common share of XYZ stock has a 100% (another way of saying +1) correlation with every other Class A common share of XYZ stock.Two assets that have a –1 correlation move exactly opposite to each other—whenever one goes up 1%, the other goes down 1%. For example, a long position in XYZ stock will have a –1 correlation with a short position in XYZ stock.

Two assets with a zero correlation have value movements that are independent of each other. For example, an investment in Australian real estate may have a zero correlation to an investment in, say, Israeli stocks—they simply have nothing to do with each other. Owning these two assets would provide a good measure of diversification, since they do not move together.

Financial theory suggests that investors should create portfolios of investments that have low or negative correlations to each other, so as to smooth out overall portfolio returns.

Cumulative return

The total amount, expressed in either dollars or percent, that an investment has earned since the beginning of its life. Contrast with annualized return.  [Note: In the example given in the definition of annualized return, the cumulative return is 20%, or $200,000.]

Derivative

An investment contract that derives its value from the price movements of another instrument. For example, a stock option is a derivative that derives its value from the price movement of the reference stock.

Diversification

The process of investing in assets that have correlations of less than +1 to each other.

EAFE

An index measuring the performance of stocks in Europe, Australia, and the Far East. That is, it describes performance of most of the stocks in the developed world except the U.S.

Efficient frontier

A line depicting the asset allocation of a theoretical set of portfolios, each of which yields the highest expected return per unit of expected volatility (or, conversely, the lowest expected volatility per unit of expected return). Based on Efficient Market theory, an academic theory that holds (in part) that, since investors are profit-maximizing rationalists, they must expect higher return as they take on more risk, e.g., add risky assets (such as stock or real estate) to a portfolio of low-risk assets (such as cash).

Portfolios that lie on the Efficient Frontier are said to be efficient, that is, expected to obtain the maximum return per unit of risk taken on. Portfolios that lie below this line as said to be inefficient, that is, expected to obtain something less than the maximum return per unit of risk taken on.

Equity

(1) Synonym for stock: A financial instrument that provides a claim on residual value after creditors have been paid. Investors in the stock market are said to hold equities. (2) Synonym for net worth: What is left for owners after liabilities are subtracted from assets.  For example, the owner of a house worth $1 million, with a mortgage against it for $400,000, is said to have equity of $600,000 in that house.

Fixed income

Another term for bond. A financial instrument that pays a set rate of interest during its life, and pays back its principal at maturity.

Fundamental analysis

Analysis of the money-making characteristics of a securities issuer. Fundamental analysis of a corporate stock would include analysis of its products, management, markets, growth prospects, profitability, level of indebtedness, and similar characteristics. Fundamental analysis of a general-obligation municipal bond would include analysis of the municipality’s population and expected change in population, tax base, level of indebtedness, funding level of public pension funds, general economic health, and similar characteristics. Contrast with technical analysis.

Future value

The value to which a sum of money invested today, at today’s rates of return, will grow, at a given point in the future. For example, the future value, one year from today, of $100 invested today, at an interest rate of 6%, is $106.

General partnership

A legal form of ownership in which investment gains and losses flow through to the investors’ (called “general partners”) tax returns, and in which the investors are legally responsible for repayment of the partnership’s debts.  Contrast with limited partnership.

Growth investing

A style of active management that seeks to outperform by buying stocks of companies that have rapidly growing sales or profits.

Hedge fund

A kind of alternative asset that typically may invest in stocks, bonds, and derivatives; long or short; and use leverage. Hedge funds are generally intended for sophisticated investors, who must meet the criteria for accredited investors or qualified purchasers.

Hurdle rate

A rate of return that must be earned by the investors in a transaction or fund before the investment manager is entitled to receive an incentive fee. Typically seen in private equity investing.

Incentive fee

Another term for carried interest. A fee charged by an investment manager based on the investment gains earned. A 20% incentive fee is typical for alternative assets investments.

Income statement

A financial statement that shows how much profit was earned over the course of a given period (such as a year or a quarter), by subtracting expenses from revenues.

Index

A benchmark that is calculated by including the returns to all of the assets meeting pre-specified criteria. See, for example, S&P 500.

IRR

Internal rate of return. The rate of return that equates all of the cash flows that went into and came out of an investment, at the time they went in or came out, with the final value. It is a form of annualized return typically used to measure investments in private equity, where money is invested gradually over time, rather than all at once.

Leverage

Borrowed money. Investors sometimes try to increase their profits by employing leverage. If the assets bought with the borrowed money earn a rate of return higher than the interest rate paid on it, profits increase. The reverse is also possible: A leveraged asset will lose value faster in a falling market than an unleveraged asset. Therefore, a portfolio that uses leverage is said to be riskier than a similar portfolio without leverage.

Liability

Something owed, or the amount thereof. Mortgages and credit card debt are examples of liabilities. Liabilities are subtracted from assets to calculate net worth.

Limited partnership

A legal form of ownership in which investment gains and losses flow through to the investors’ (called “limited partners”) tax returns, and in which the investors are not legally responsible for repayment of the partnership’s debts except to the extent of the amount invested. Contrast with general partnership. This form of legal entity is commonly used by hedge funds and private equity funds.

Long

Own / buy / owned / bought. An investor who is long a stock owns shares of it. The opposite, in this context, of short.

Management fee

A fee charged for managing money, usually as a percent of the value of assets managed. Typically ranges from about 25 basis points to 2% of assets, depending on the asset class. Also sometimes called a “base fee”, particularly when an incentive fee is also charged.

Marginal income tax rate

Tax rate paid on the last dollar of income.

Mean-variance analysis

A method of statistical analysis of future outcomes that looks at the mean [average] outcome, plus or minus the outcomes at (typically) one or two standard deviations away from the mean. A weakness of mean-variance analysis is that it does not calculate the probabilities of what happens between these discrete points (e.g., the five points represented by the mean outcome and the outcomes that lie +/- one and +/- two standard deviations away from the mean).

Monte Carlo simulation

A method of statistical analysis that is used to determine the likelihood of various future outcomes, by randomizing the occurrence of future events, such as the path of future stock market returns, and then comparing outcomes over many trials (= iterations of the test).

Muni(cipal bond)

A bond issued by a municipality (city, township, etc.) or agency of a municipality. Munis are usually exempt from federal income taxes and state (and local) taxes for taxpayers residing in the issuing state (and municipality). Therefore, municipal bonds may be good investments for investors who pay high marginal income tax rates.

Mutual fund

A pool of assets (stocks, bonds, or both) from many different investors, managed collectively. Generally have low minimum investments; do not require investors to meet net worth criteria; charge only a management fee; do not use leverage; may accept as many investors as they wish; and are overseen by the Securities and Exchange Commission, an agency of the federal government.

Net worth

(1) Amount left after subtracting liabilities from assets.  (2) The sum on a company balance sheet of capital stock (par value of stock sold by the company to the public) + capital surplus (excess over par paid by buyers of stock sold by the company) + retained earnings.

Option

A contract that gives its holder the right, but not the obligation, either to buy (a “call” option) or to sell (a “put” option) a specified asset at a specified price for a specified period of time.

Outperform

Earn a better return than a specified benchmark or peer group.

Passive management

Investing that seeks to match, rather than beat, a benchmark. Passive managers typically hold all, or almost all, of the components of the benchmark, so that the only difference between the performance of the investment and that of the benchmark itself will be the fee the manager charges. Fees for passive management are usually much lower than fees for active management.

Price / earnings ratio

A valuation ratio for stocks that compares the current price of a share of stock to the current or projected earnings per share of the issuing company. The higher the P/E ratio of a stock, the more expensively valued it is said to be. The P/E ratio of U.S. stocks has, on average, tended to be in the mid-teens. That is, investors typically pay a price of about $14 – $16 for $1 of earnings.

Private equity

An ownership interest in a company the shares of which are not traded on any exchange or otherwise available to the public.  The two main kinds of private equity are buyouts and venture capital.

Qualified Purchaser

A term defined by federal securities law to denote an investor permitted to invest in certain types of higher-risk investments, such as private equity limited partnerships. Currently this definition includes individual investors holding assets of at least $5 million. General Partners of limited partnerships that accept only Qualified Purchasers, and which limit the investor base to a maximum of 500 such investors, have historically been exempt from registration requirements with the Securities and Exchange Commission. Sometimes also referred to as “Super-Accredited Investors”. See also Accredited Investor.

Real value

Value after removing the effects of inflation.

Relative return

Return compared to a benchmark.

Relative risk

Underperformance compared to a benchmark.  Contrast with absolute risk.

S&P 500

A widely-used gauge of the performance of the US stock market. It is calculated, approximately, as the return to the 500 biggest US companies, by market capitalization of their stocks (= number of shares outstanding X price per share), with each return weighted by market capitalization. Thus, a stock with a capitalization of $100 billion will “count” ten times as much as stock with a capitalization of $10 billion.

Separate account

A pool of assets directly owned by an investor, rather than being combined with the assets of other investors. Contrast with mutual fund and limited partnership.

Short

An asset sold but not owned, on which profit will be earned if the price of the asset declines. An investor who shorts a stock borrows shares from someone who does own them; sells them at today’s price; and buys them back later, at what s/he hopes is a lower price, to give back to the lender. Used as a verb, the action of taking a short position.

Investors almost always want to “buy low and sell high”. An investor who is short simply tries to do it in the reverse order.

For example, an investor who sells a stock short at $10 today, and buys it back for $8 next month, has made a profit of $2 from this short sale.

Standard deviation

A statistical calculation that describes how far from the average of a set of numbers the individual numbers that make up the set are. In investing, this is used to describe how risky an asset is.

For example, consider two sets of numbers: (1) 7, 3, 8; or (2) –12, 20, 10. Both of these sets of numbers add up to 18, and therefore the average of the 3 numbers in each case is 6. However, the individual components in the second set are much farther away from the average, and so the second set would have a higher standard deviation.

Standard deviation is calculated such that approximately 2/3 of the individual numbers fall within a band of plus or minus one standard deviation of the average; 95% fall within +/- two standard deviations; and 99% fall within +/- three standard deviations. (Note, however, that this is true only for “normal” bell-curve distributions, which represents most, but not all, sets of data.)

Standard deviation is often used interchangeably with volatility. Both refer to the riskiness of an asset. The higher the standard deviation of the individual observations of its returns (for example, its quarterly returns or its yearly returns) around the average of these returns, the riskier the asset is said to be.

An intuitive way to understand why standard deviation is a measure of risk is to note that, when standard deviation is high, knowing what the “average” return is doesn’t tell the investor much about what he or she individually can expect to earn.

Over the very long term, the U.S. stock market has tended toward an average return of about 9% – 10%, with a standard deviation of about 18%. Thus, in two-thirds of individual years, investment returns typically fall between about +28% and -9%.

Stock

A financial instrument representing ownership in a company’s net worth. Sometimes called equity.

Style

Refers to the subsector within an asset class in which an investment manager invests. Investment professionals generally differentiate between growth and value styles, and between investments in large companies or small companies.  Thus, a reference to a “US s/mid value” manager means a manager who invests in small and mid-sized companies based in the U.S., and that s/he believes are selling at a discount to fair value.

Technical analysis

Analysis of the past trading prices and patterns of a security, in the belief that they are predictive of future performance.

Top-down analysis

Analysis that starts at a “macro” level and then proceeds to a more “micro” level. Top-down analysis might start with a consideration of global economic growth, then proceed to examination of growth prospects of individual countries, then analyze industries, then select individual companies for investment. Contrast with “bottom-up” analysis, which works the other way.

Underperform

Earn a worse return than a specified benchmark or peer group.

Unfunded commitments

Financial commitments made, but not yet funded, such as capital commitments to a private equity fund that have not yet been called (i.e., the general partner has not yet asked for the money).

Value investing

Style of active management in which a manager tries to outperform benchmarks or peers by finding assets that are cheap compared to their assets or earnings.

Venture capital

Private equity investments in young, new, and/or small companies, the stock of which typically has never been traded on a public exchange, such as the New York Stock Exchange. Contrast with buyouts.

Volatility

Fluctuations up and down. A measure of riskiness; often used interchangeably with standard deviation.