(ten minute read)
A thorough knowledge of financial terminology is not just for those working in the industry. Understanding the basics of this portal is for everyone who relies on the currency of paper money because you are either one of the two: thriving or surviving with needs that require some degree of monetary attention.
Let’s talk language, communicating, and understanding. On the learning curve front, I get you. I was once a fresh face at the starting line not so many years ago; 9 to be exact.
Early 2007 I entered the financial services industry as a licensed Investment Advisor. Unbeknownst to my early 20’s self, I signed up for a new language during a time in economic history of a rapid shift from a bear market to a bull market, and back again in heavy economic uncertainly and global political uproar. Critical thinking and timely, accurate response – a must.
With a brief overview of the following few terms to begin with, allow me to help you better understand the terminology of the playing field and how to confidently walk your finance talk.
ROI stands for return on investment. A return is something you can expect to receive in exchange for something else. Returns can be positive or negative, making the investment either a gain or a loss. Investments come in all shapes and forms be it purchasing a home, investing in the stock market, your education, a relationship, something tangible or an intangible experience. The weight you place on the investment’s value, another topic.
ROI is a financial metric in that it is used to measure the return or conversely loss, you receive from an investment. Calculating ROI = the gain (or loss) you have made minus the cost of the initial investment, divided by the cost of the initial investment.
Take away: ROI can be positive or negative, and this number is a percentage of your initial investment expressed as a gain or a loss.
Overhead is a term that I want you to correlate with “expenses” or “operating costs”. Your overhead is the amount of money required ongoing to operate your life, business, whatever have you. Both the necessaries and extra ordinary’s in terms of expenses equate to the support it takes to make your life continuously flow. This is your overhead.
Operating expenses for your personal life might include bills such as your: mobile, internet, Netflix, heat/power/water, property taxes, mortgage, health care, food, transit, Uber or gas, etc. I would also add in personal monthly expenses you incur such as: hair cut or color, facial, manicure, acupuncture, personal training/gym membership, spin class, yoga, anything of a personal nature ongoing that requires upkeep and dollars to maintain whatever the expense might be.
Operating expenses for your business (solopreneur, business owner, independent operator within a business you’re affiliated with or otherwise) might include bills such the same as personal, minus personal expenditures, plus the cost of professional services, subscriptions, memberships, travel, vehicle, etc. In the world of accounting, check with your professional accountant on what can actually be included as tax deductible operating expenses if you have an at home business.
Take away: speaking to personal finance, when you reduce the amount of expenses you must deduct from your income, you are left you with a higher dollar amount to allocate to disposable income and discretionary spending. Trim the fat and don’t spend on excess expenses unnecessarily. Unnecessary spending means you will have less to invest and save. Treat savings as an expense on your personal payroll list, and not as discretionary investments.
Amortization is alike the concept of depreciation, however it differs in that amortization refers to the repayment of an intangible asset over a fixed period of time and depreciation refers to the devaluation of a tangible asset over its useful lifetime. Best said, amortization is the repayment of a loan over a fixed period of time.
Think: your mortgage or a car loan both are debts that need to be repaid, neither the average person generally does in full up front. Your credit card also fits into this category of an amortized payment schedule, should you not pay it off in full. Different type of loan than your mortgage or car loan, though same concept in repayment.
How amortization works:
- A down payment is made on a purchase (the asset), and the amount left to retire on the loan (amount borrowed) is a combination of two things: the interest on the loan and the principal amount of the loan.
- The principal repayment retires the value of the asset itself (the mortgage or car loan).
- The interest repayment pertains to the percentage owed on the amount borrowed.
- Your fixed payments will include a heavier repayment of the interest portion of the loan near the beginning of the loan, and towards the end of the loan, the bulk of your fixed payment will be spent retiring the principal amount of the loan.
- Note: there are two types of interest, compound and simple, both of which we will cover in another post. What you need to know is that compound interest is interest that accumulates on both the interest and the principal of the loan during the repayment schedule, and the interest type linked to most long-term loans. Essentially, you pay interest on interest when you are paying compound interest.
- Compound interest is a positive when you are earning on the money on a deposit (savings), and a great wealth creator. Compound interest is a negative attribute when you owe money (on a loan), and in this case is a serious villain to your wealth’s demise.
Think: someone lends you money. In theory and best practice you repay that money before you can buy, save or invest in something for yourself. Hence, although repaying interest plus principal on each payment, you repay the interest portion at a more rapid pace than the principal. Although the total amount of the loan is an owed amount, the interest is what you owe for borrowing, and the principal is what you owe in exchange for owning the actual asset.
In business, amortization can also refer to intangible assets such as intellectual priority; patents, copyrights, and trademarks.
Don’t borrow money from a lender unless you absolutely must. No interest rate is the best interest rate and the easiest amortization calculation at that.
Do borrow money to invest in securities. Borrow this money from a financial institution such as a bank not a credit card lender, just to be clear. The interest is tax-deductible.
4. TAX DEFERRED AND TAX ADVANTAGED
Tax-deferred simply means deferring taxes being paid on income until a later date.
Strategy one in tax-deferral is contributing to a registered savings account. By contributing to a RRSP or TFSA (in Canada), $401(k) or IRA (in the U.S.) and other unmentioned, qualified registered savings accounts, you defer paying tax on the amount you contribute today, until you withdraw that money at a future date.
- The maximum amount you are able to contribute to these accounts each year is determined as percentage of your earned income up to a maximum value.
- The space you’re able to contribute for is carried forward indefinitely, should you not make the maximum contribution you’re able in any given year – which means, you can play catch up by topping your account up in the future when you have the excess to contribute!
- Upon contribution, you receive a tax deduction on your current year’s reported income as a result of making a contribution to one of these registered accounts. You then only pay tax on the total amount when it is taken out, presumably when you are in a lower tax bracket, upon retirement or upon shifting into a less high-income earning bracket.
- The higher your income, the higher your tax bracket.
- In retirement, it is assumed you will be earning a lower income and are part of a lower tax bracket then when initially making the contributions.
Strategy two in tax-deferral is regarding investment allocation into these registered accounts. Tax-advantaged refers to strategically allocating investments into appropriate account types for tax-smart purposes, allowing investments within these accounts to grow in a tax safe environment until they are withdrawn. Tax safe also meaning tax-deferred.
These investments are generally securities set to receive interest income, dividends, or appreciate (incur capital gains) and count as tax-advantaged investments when held in a registered account.
Diversification simply refers to not putting all of your eggs in one basket. In a financial sense, diversification can be classified as risk management. I’m sure you’ve heard about a defensive strategy being used in sports, life, and otherwise. Alike the defensive game a strong team brings, your portfolio can benefit by holding in part stocks that perform defensively.
Based on your investment profile, including risk tolerance and time horizon, varying degrees of cash and cash equivalents, equities and fixed income securities are allocated to your portfolio.
Defense refers to a relatively consistent expected state of performance regardless of external circumstances. For example, if the market is performing negatively and a stock declines by x%. Regardless of that fluctuation, you will still reap the benefit of being paid a dividend by that stock. Blue chip companies with strong fundamentals are examples of stocks that perform defensively. Blue chip companies are those who are well-established, financially sound, market leaders. Think: names such as Verizon, Chevron, Wal-Mart, Fortis.
Yes, I did say Chevron (an energy company). Energy stocks are subject to fluctuation when commodities and the price of oil are low, though the point of a defensive performing stock is that they steadily continue to pay that dividend. Dividends are subject to being cut, however it takes significant circumstances for a well established blue chip company to do so. Depending on your time horizon, short-term fluctuations should matter little. Focus on the long term divided (and income) you are continuously receiving each quarter.
By investing in securities that are not all reactive to the same external circumstances that create fluctuations, a portfolio is able to offset any negative fluctuations with securities that should perform positively during that the same period.
Think of the diversification within a portfolio like the elements of water, fire, air and earth. Without the diversification of each of these elements, the environment in which they all inhabit would never perform as effectively.
Diversification is far more in depth as per each individual’s needs, circumstance and investment profile, though not necessarily complex. The above is one example on a security that is pro-diversification, regardless of the market’s performance any any given time. Most, if not all portfolios contain income-producing (dividend paying) securities.[line]
More to come on “Financial Terms You Need to Know” come future posts. This is edition one.
Any terms you’re itching to learn about? Fire me an email.