Do You Alpha? Understanding Common Investing Terminology
Only 57% of US adults are financially literate, according to the 2014 S7O Global Financial Literacy Survey. Entering the world of investing can be intimidating for retail investors, especially when confronted with some of the jargon. Whether it’s to be able to read a regulatory filing or to understand a research report, here are some common investing terms that every investor should understand.
Starting with the various styles of equity investing, it’s important to understand the difference between growth and value stocks. Growth stocks are shares in companies that are expected to grow at an above-average rate. Although growth stocks don’t typically pay a dividend, which is a portion of profits paid quarterly by some companies, investors can expect high capital gains when selling their exposure. On the other hand, value stocks are more attractive to long-term investors who want to find undervalued companies. Value investors like Warren Buffett seek sound businesses with solid fundamentals that have been mispriced and hope for the stocks to eventually perform at a level that reflects their intrinsic value.
In terms of investment styles, investors can also be categorized between those seeking alpha, and those following beta. Alpha is the measurement of a manager’s ability to outperform a market index. Generally speaking, investments actively managed by a firm produce higher alpha than those simply following an index. Then there’s beta, the measurement of the volatility of a stock compared to a market index, or the stock’s sensitivity in the market. As opposed to alpha, beta is related to passive investing. To complicate matters a bit more, there’s also smart beta, which refers to a strategy based on index investing but with the goal to outperform it by picking customized exchange-traded funds based on a few selected factors.
In fixed income, the world of bonds and loans, an essential tool to see the overall picture is the way interest rates and yields work. The interest rate of a bond is the percentage paid to the debtholder annually. The yield is what an investor actually earns. If the investor holds the debt until its maturity, the yield and the interest rate are the same. But it becomes tricky if the bond or loan is sold on the secondary market, which happens very often. If the debt is traded, the interest rate will always stay the same, but the yield will change because the new buyer paid a different price for it, and that new basis affects the yield. If an investor bought a bond at a discount, it will produce a higher yield. If the investor bought it at a premium, the yield will be lower.
Continuing on the yield theme, investors often hear of high-yield bonds. Also called junk, these are bonds from companies that are rated below BBB on the credit rating ladder. It signifies that they are risky investments. Although they offer higher yields than higher-rated companies, those that are called investment grade, companies rated junk are much closer to defaulting on their debt (not making their monthly payments) and eventually closer to going bankrupt.
Now you’ve decided whether you’re investing in equity or debt and which strategy to follow, it’s time to value a potential investment.
Some terms necessary to size up a company include market capitalization, or market cap, which is the total value of a company’s stock calculated by multiplying the number of outstanding shares by the stock price. Earnings per share, or EPS, helps grasp the profitability of a company. It’s calculated by dividing a company’s net income by the total number of outstanding shares
Net asset value, or NAV, is useful to understand a fund’s market value and how much one share of the fund is worth. It is calculated by dividing the total value of the cash and securities in a fund’s portfolio minus any liabilities, by the number of outstanding shares.
In the current environment, investors are increasingly interested in sustainable investments. Many companies and investment managers are presenting themselves as ESG- or impact-focused to describe green and socially-conscious investments, so it’s important to understand the distinction between ESG and impact.
ESG investing is aimed at taking into consideration the environment, including climate change, social issues and governance issues, to avoid doing harm, while still making a financial return. This is usually done by following an investor’s preferences, values and ethics and it’s not so much about doing good but it’s certainly about not harming anyone or the environment. Examples of ESG strategies include refraining from investing in tobacco, gun or fossil fuel companies.
Impact investing goes one step further than ESG and is done with the actual intention to generate positive, measurable social and environmental impact while generating a financial return. Examples of impact investing include investing in renewable energy or in medical research.
Understanding key investing concepts is helpful in conducting proper due diligence, making sound investments and managing risk. These terms can help you learn more about investing, and communicate more effectively with people who live and breathe the investment world.