13 terms to help you better understand investments
This article will help you learn the lingo and be better equipped to discuss investments with your personal finance expert.
When it comes to talking about money, the terminology can sometimes be overwhelming. Nonetheless, you need to know the basics to make smart investment choices. There are several types of investments that you can then invest in an RRSP or TFSA, including mutual funds (FCP), stocks, exchange-traded funds (ETF) and guaranteed investment certificates (GIC), which are the most popular.
Below are a few important terms related to investments that may prove useful during your next meeting with your personal finance expert.
Key terms related to investments
A share is fraction of a company. When you buy a share, you own a portion of the business. As a shareholder, you can regularly receive a portion of the company's profits (i.e., a dividend) and even make a profit by selling your shares later if the company has appreciated in value.
Capital is the cash value of the assets and investments you own. Examples of capital are shares, bonds, and the money in a chequing account. Your home is considered a capital asset because you could cash in its value if you were to sell it. However, capital should not be confused with net assets, that is, your capital minus your debts.
A mutual fund is a type of investment fund that pools your money with that of other investors. Mutual funds can be composed of various types of investments, such as stocks or bonds. They are therefore suitable for many risk profiles and a variety of investment strategies, such as venture capital and capital protection, foreign investment, and responsible investment.
Exchange-traded funds (ETFs) are also becoming increasingly popular in investment portfolios. Like mutual funds, ETFs are composed of many different assets and have the same structure: individuals invest their money so it can be managed by an expert. However, these two distinct products should not be confused.
Investment time horizon
This is the period over which you plan to hold your investments before you start cashing more than one third of the amount. Depending on your savings goals, you may choose different time horizons. For example, you might choose a short-term horizon to save for a trip and a long-term horizon for retirement savings.
A savings goal is your reason for saving. It is based on your needs and aspirations. Savings goals therefore vary greatly from one person to another and over the course of a person's life. For example, your goal might be to save for a home, your retirement, activities, travel, or to leave money to your loved ones. It's important to define your goals carefully because these will guide your entire financial strategy, including your saving needs, time horizons, and risk tolerance.
Making an investment consists of placing money (capital) in different types of securities—for instance, stocks or bonds—to earn income later in the form of dividends or interest, for example. There is a type of investment for different investor profile. While some guarantee capital or return, others are purely speculative.
These are investments that guarantee that the money invested will never be lost, as the capital is protected. Most guaranteed investments also assure a return on the investment by offering a fixed and predictable interest rate or rate of return. Guaranteed investment certificates (GICs) and government savings bonds are the most common guaranteed investments. Although this type of investment generally offers the lowest returns, it is a low-risk option that provides an accurate idea of expected earnings.
Creating an investor profile will help you determine your financial situation, risk tolerance, investment objectives, time horizons, and so forth. It's important to know your profile before you make your first investment to be sure that you're making the right choice. A mutual fund advisor or personal finance expert can create an investor profile for you the first time you meet. It's essential to review it regularly, as it will change according to your plans and over the course of your life.
Management expense ratio (MER)
Management fees are applied to the total value of an individual's investments and are used to cover the costs of administering and managing the portfolio. These fees can vary considerably depending on the type of investment, ranging from as little as 0.05% to more than 3%, which can add up to several thousand dollars a year.
The return is the profit you make from your investment. It is often expressed as a percentage. Annualized return means the return you have (or would have) obtained on average over a full year. For example, if a $1,000 investment yields $60 after two years, its total rate of return is 6% and its annualized rate of return is 2.96% a year over two years. If the same $1,000 investment yields $60 after only six months, it has an annualized return of 12.36%.
The risk associated with an investment is the probability that the return will not be as expected or that the capital will depreciate in value. Generally speaking, the level of risk of an investment depends on the potential return: the greater the potential return, the greater the risk. Conversely, if the capital is protected and the return is predetermined, the level of risk will be lower, as will the return. There are many types of risks. The most well known are market risks, interest rate risks, exchange rate risks, inflation risks, and—depending on the country—geopolitical risks.
Fixed income investments
This type of investment offers a predetermined return, so you know exactly what your earnings will be. It can generate a continuous and regular income for the entire term of your investment. Guaranteed investment certificates and savings bonds are the most common fixed income investments.
Risk tolerance is your ability to manage a depreciation in your investments, even temporarily, without your savings goals being affected. Your risk tolerance depends on your investment time horizon, your standard of living, your desired returns, and even your personality. If the slightest change in the value of your investments affects your standard of living or causes you stress, your risk tolerance may be low. On the other hand, if you plan to hold your investments for many years and you have an emergency fund to maintain your standard of living, your risk tolerance may be high.
This is the value of an investment that you could redeem if you were to sell your investment on a specific date. For example, if you own 100 company shares, each of which is worth $10 when the market closes, your investment has a market value of $1,000 on that date. The market value of your investments varies with market fluctuations and may change daily. Be careful not to confuse market value with the value of your net assets, which represents your total assets (your capital and your debts).
Savings vehicles allow you to accumulate your savings and hold your investments. There are many types of savings vehicles, including all types of savings plans and non-registered accounts, such as chequing accounts at financial institutions. The most well-known savings plans are the registered retirement savings plan (RRSP), the tax-free savings account (TFSA), the registered education savings plan (RESP), the registered disability savings plan (RDSP), and the locked-in retirement account (LIRA). This category also includes employer pension plans such as the Régime de retraite des employés du gouvernement et des organismes publics (RREGOP).