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Personal Finance: Glossary of terms, concepts

August 3, 2011

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Guide to Personal Finance
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Personal finance covers the gamut from credit cards and investments to student loans and insurance. It’s important that you have a good understanding of the basic terms and concepts so you can cut through the jargon.

Here are the ones you should know:

ADJUSTED GROSS INCOME: AGI is a measure of income used to determine your taxable income. It’s calculated as your gross income minus deductions, such as unreimbursed business expenses,  medical expenses and deductible retirement plan contributions.

ANNUAL PERCENTAGE RATE OR APR: This tells you the annual cost of a loan and is stated as a percentage. The APR consists of the base interest rate and loan fees and costs. With credit cards, the APR is charged on credit card balances each month that there’s an outstanding balance.

ANNUITY: An annuity is a contract between you and an insurance company that’s designed to meet retirement and other long-range goals. You  make a lump-sum payment or series of payments to the insurance company. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date.

In a fixed annuity, the insurance company pays you a specified rate of interest during the time that your account is growing. The insurance company also agrees that the periodic payments will be a specified amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

In a variable annuity, you typically invest your purchase payments in mutual funds. The rate of return and the amount the insurance company pays you  will vary depending on the performance of the investment options you’ve selected.

ASSET ALLOCATION: Asset allocation is determining how to divvy up your money among various investments, such as stocks, bonds or cash. Once you determine what asset classes you want in your investment portfolio, you then determine how to mix those in the right proportions so you can reach your investment goals at the level of risk you’re comfortable with.

BOND PRICES AND INTEREST RATES: Bonds are highly sensitive to interest rates, so bond prices move inversely to interest rates. This means that when interest rates rise, bond prices fall. Conversely, when rates fall, bond prices rise. Many readers don’t understand this concept, so it’s important that you are able to explain it to them.

When interest rates rise, it depresses the prices of previously issued bonds because their interest rates are fixed. So if you have a bond that’s paying 6 percent interest and market rates rise to 8 percent, the only way you could sell your bond is to lower its price.

However, if rates fall to 3 percent, your bond that’s paying 6 percent interest will be more valuable to investors and you could sell that bond at a premium over its face value because the 6 percent rate would be higher than the market rate.

All this doesn’t affect investors who hold a bond until it matures because the value of the bond doesn’t change because interest rates fluctuate. They will get the full principal back at maturity. However, those who buy and sell bonds have to pay close attention to interest rates.

CAPITAL GAIN: The profit you get from selling a stock over your original purchase price.

CAPITAL LOSS: The loss you incur from selling a stock from your original purchase price.

COST BASIS: The basis is the purchase price of an investment, including commissions and other expenses. The basis is also adjusted for stock splits, dividends and return of capital distributions. The basis is a critical figure because it’s used to determine capital gains and losses for income tax.

CREDIT BUREAU: Also called a “credit reporting agency,” a credit bureau is a company that collects and sells information about a person’s creditworthiness. The three major credit bureaus are Experian, TransUnion and Equifax.

CREDIT REPORT: Issued by a credit bureau, a credit report contains information on a person’s payment history, bankruptcies, loans and recent inquiries to obtain credit. By federal law, consumers are entitled to one free credit report once every 12 months from each of the three credit bureaus. Consumers can get their free credit report by going to www.annualcreditreport.com.

CREDIT SCORE: A credit score is a three-digit number that’s designed to predict the likelihood of your repaying a loan. The score is based on a snapshot of your credit report at a particular point in time. The most widely used scores are FICO scores. Lenders can buy FICO scores from all three major credit bureaus.

DIVERSIFICATION: This reduces the risk in your investment portfolio by including a variety of investments, such as U.S. stocks and stocks from other countries, as well as bonds and cash. The rationale behind this technique is that different types of investments will pose a lower risk than any one investment that you hold. Diversification differs from asset allocation in that in asset allocation, you decide what percentage of your money you want to go to stocks, bonds and cash.

DIVIDEND: This is income that a company pays its shareholders and is distributed from a portion of the company’s earnings. It’s typically quoted as a dollar amount per share.

PRICE/EARNINGS RATIO: Also known as the P/E ratio, it’s a stock’s current price divided by the earnings per share. It’s a widely used tool of stock analysis and gives you an idea of how expensive or cheap a stock is.

REBALANCING: Adjusting your investment portfolio to bring it back to your original asset allocation mix. Movements in the stock market can throw your asset allocation out of kilter. For example, if you originally wanted 50 percent stocks and 50 percent bonds in your portfolio, strong performance of your stocks can lift the stock portion of your portfolio to 70 percent. So in order to bring that portion back to 50 percent, you “rebalance” by selling some of your stocks and buying bonds to bring the allocation back to 50/50.

RISK TOLERANCE: An investor’s ability to tolerate declines in the value of his or her investment portfolio.

Bloomberg’s David Evans answers questions on insurance stories after a Reynolds Center session. Photo: Linda Austin

TAX DEDUCTION: An expense that’s subtracted from your adjusted gross income and reduces your taxable income. An example is the home mortgage interest deduction. A deduction differs from a tax credit, which is a direct dollar-for-dollar reduction of your tax liability. Examples are the child tax credit and Earned  Income Tax Credit.

TERM LIFE INSURANCE: Term life insurance pays off only if the policyholder dies within a specified time period or “term.” This differs from “whole life insurance,” which provides coverage for your whole life instead of a specified term. A whole life policy also has a savings component called cash value, which builds over time.

TIME HORIZON: The length of time you expect to invest your money before you cash out.

TRUST: A legal vehicle you set up in estate planning that enables you to transfer legal title to an asset to another party, the trustee, who has the duty to hold and manage the asset for the benefit of a beneficiary or beneficiaries. You can use a trust to pass assets to your children, disabled adults, heirs who aren’t good at managing money and any others you believe lack management skills and judgment.


And speaking of trust, Most average investors don’t know the difference among financial advisers. They have enough trouble distinguishing among the alphabet soup of professional designations that advisers put on their business cards.

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Investors’ main concern is that when they hire a professional to advise them on their finances, they want to be confident that that person has their best interest in mind.

Most people think there’s no difference between a stockbroker and an investment adviser. While they may use those two terms interchangeably, they are not the same thing.

Brokers and investment advisers are regulated by different standards under federal law when providing investment advice.

Because the average investor doesn’t know the difference, he or she may enter into a business relationship with the wrong assumptions.

Stockbrokers are financial professionals who buy and sell securities on behalf of clients. They’re also known as financial consultants, financial advisers and investment consultants.

Stockbrokers are governed by the “suitability rule,” which means they’re required to recommend investments that are suitable for you based on their knowledge of your financial situation and needs.

Investment advisers, on the other hand, are required to exercise “fiduciary responsibility,” which means they have to put your interests ahead of theirs at all times when providing advice and recommendations.

The term “investment adviser” describes a broad range of people who give advice about securities, such as stocks, bonds, mutual funds and annuities. Investment advisers also may go by the titles of investment manager, investment counsel, asset manager, wealth manager or portfolio manager.

Most investment advisers charge a fee based on a percentage of the assets in your account. Typically the larger your account, the lower the percentage.

Stockbrokers are typically paid through commissions paid each time the broker buys or sells a security for a client.

Since many investors don’t know the difference between investment advisers and brokers, they assume that all financial advisers are always required to put an investor’s best interest first.

Most brokers do have their client’s best interest at heart when making investment recommendations, but they’re not required to meet this standard.

Consumer advocates, financial planners and brokerage industry representatives have said the fiduciary standard should apply to both investment advisers and brokers.

The Dodd-Frank financial-regulatory reform law directed the Securities and Exchange Commission to conduct a study of the effectiveness of current standards for brokers and investment advisers, and whether there are gaps, shortcomings or overlaps in the current regulations.

A SEC study has recommended one fiduciary standard for brokers and investment advisers.


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