Least Understood Financial Terms
I recently read an article about a survey conducted on consumer confidence around financial terminology. Very simply, respondents were asked to indicate how confident they were in understanding certain terms. Terms that ranked highest in confidence were things like savings account, credit union and net worth.
Where I wanted to focus today is on a few words that ranked lowest in the confidence column. We try very intentionally at TAAG to speak as plainly as possible, not because we don’t think clients and others can’t understand, but because in a typical meeting where many personal financial topics are discussed, it’s far too easy to get lost in translation.
Even in our attempt to speak plainly, we don’t always succeed. I know I’m guilty of using at least a few of these words fairly often. While I don’t think it’s necessary to turn all of our readers into financial thesauruses, I thought it might be worth a deeper dive into a few of the least understood words.
Use of this term seems to have ramped up significantly in the last decade, though I’m not sure why. Essentially, liquidity is just a measure of how quickly and easily an asset can be converted to cash. In other words, cash is the most liquid asset as nothing needs to be done to turn it into spendable, well, cash.
A checking account is more liquid than a savings account as you typically have a debit card and/or checkbook to access funds. A savings account is more liquid than a certificate of deposit, as CD funds are tied up for some period in exchange for a higher rate of interest. You get the idea.
As you look at the investment world, however, it can get a little more complicated. Stocks and mutual funds are generally considered liquid vehicles as they can be sold and converted to cash on any day that the market is open. That said, they are constantly changing in value, meaning you may have to face a financial loss if forced to sell such an asset at a certain time.
There are many other types of assets that are much less liquid. The easiest example is real estate, since it might be difficult to sell a home or rental property at a moment’s notice to create cash. It might also significantly impact the value if you must sell with urgency. Master limited partnerships, oil rights, ownership interests in private companies, artwork and stamps are some other examples of assets that would be considered illiquid.
Liquidity is why we recommend people keep a certain amount of money in emergency savings. It’s also why we tend to keep at least some cash or very short-term, high quality bond funds in portfolios in case the need for cash or an unexpected investment opportunity arises.
Capital Gain & Loss (Realized & Unrealized; Short-term & Long-term)
A capital gain is the rise in value of an asset. Picture a share of stock you purchased at the beginning of the year for $5 that you still hold and is now worth $15. In this instance, you have a capital gain of $10.
Let’s take care of the short vs. long-term portion quickly. Generally, if you sell something at a gain in less than a year from purchase, you recognize the gain or profit on that sale as ordinary income for tax purposes. If you wait a year or more before recognizing the gain, that profit is treated as a capital gain, which often has a more favorable treatment for tax purposes. In our example, your gain is still short-term.
As for realized vs. unrealized, that’s simply a matter of whether you’ve sold the asset or not. Any assets held at a gain or loss are considered unrealized. This is also often referred to as gains or losses “on paper” because, while in our earlier example, you may have a gain of $10, if the stock drops to $10 tomorrow, you never really had the $10 gain, which is now only $5. It was just “on paper” or unrealized.
As you might guess, a gain becomes realized once you act. Going back to our example, if your $5 share of stock rises to $20 and you sell it, that $15 gain becomes realized at the moment of sale.
The same holds true for losses. Capital gains and losses can sometimes be used to offset one another for tax purposes. You’ll hear terms like tax loss harvesting regarding these types of strategies.
Perhaps I should spend time defining mutual fund first (See “Other Terms” below), but an index fund is a type of mutual fund that seeks to replicate a particular market index. Perhaps the best-known market index is the S&P 500 which tracks the 500 largest U.S. companies. There are indices that track all kinds of companies. Large, small, value, growth, domestic, foreign, etc. Index funds can also track bond or other types of investment indices as well.
Unlike an actively managed fund, or a fund where a manger seeks to execute on a certain strategy or selection process that she thinks will outperform the market or other strategies, an index fund only seeks to match the performance of whatever index it tracks.
Index funds are also known for their lower than average cost and low turnover (how often holdings in the fund are traded).
I didn’t cover all the terms mentioned in the article, but you can click on the following to see definitions for Endowment, Mutual Fund, Roth IRA, or Amortization. If you do come across a term that you don’t have as full a grasp on as you’d like, a great resource we use to help discern financial terms is Investopedia (Full disclosure: I and other TAAG advisors contribute to Investopedia’s Advisor Insights page). Simply navigate to their website and type in virtually any terms for the definition and links to better understand the term in context.
More importantly, don’t ever hesitate to ask your advisor to explain any concept regarding your finances to you in more detail if you would like more understanding.