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| Glossary |
Glossary
Active Management: In traditional portfolio management the manager seeks to select only the best stocks or bonds from those available
in an attempt to earn an above average return. The S&P 500 (described below) is an index containing 500 of the largest companies in the
U.S. stock market. Some of these stocks will generate returns significantly higher than the average of the 500 stocks while other stocks will
generate poor returns. An active manager will select only those stocks which they believe have the best prospects for generating an above
average return while attempting to avoid the worst stocks. If a stocks prospects change for the worse the manager will sell that stock and
buy a stock with better prospects. The manager actively buys and sells stocks as new information comes to light affecting the prospects for
stocks in an attempt to earn a better return than the average of all 500 stocks in the index. Active management requires research to identify
the “best” companies which is expensive and adds to the cost of managing the portfolio. In addition, all that buying and selling generate
brokerage commissions which increase the cost of managing the portfolio. These costs and efficient markets make it difficult for active
managers to beat their target index.
A Shares: Broker distributed mutual funds are sold with a number of different share classes each with a different sales load structure. A
shares are sold to investors with a front end load meaning the investor is charged the commission up front upon making the investment. A
typical front end load is 5.5% meaning an investor with $25,000 would pay a sales charge of $1,375 and the remaining $23,625 would be
invested in the fund. B shares are sold with a back end load also called a contingent deferred sales charge. If investors hold the fund for a
certain number of years they pay no sales charge. Those that sell early pay a sales charge based on the number of years they have been
in the fund. B shares might be sold with a 5.5% contingent deferred sales charge over five years. If investors sell their shares in the fund
during the first year they would pay a sales load of 5.5%. If they sell during the second year the load drops to 4.5%, to 3.5 in the third year,
2.5% in the fourth year and 1.5% in the fifth year. There would be no sales charge for investors selling after five years.
It would appear that the B shares are less expensive if you hold for five years. That is not the case. Both share classes charge ongoing
expenses to compensate the mutual fund company. Remember, the sales load goes to the broker while the fund is compensated by annual
expenses. A shares may charge annual expenses of 1% while B shares may charge 2%. During the first year A share investors pay 1% of
$23,625 or $236.25 while B share investors pay 2% of $25,000 or $500. Over five years if you assume no growth in the fund investors
holding A shares will pay annual expenses totaling $1,181 while holders of B shares will pay $2,500. If you add the front end load paid by
holders of A shares their costs over five years totaled $2,556 which is slightly more than paid by holders of B shares. Of course we
assumed no growth in the account. With average returns holders of B shares would have paid more. Over ten years the total costs for
holders of A shares would be $3,737 while holders of B shares would pay $5,000 again assuming no growth. If you assume the fund will
grow annually at average rates the holders of B shares are paying 1% more annually on an ever increasing amount than holders of A
shares. A shares are always the least expensive option yet B shares are often sold because investors believe that in avoiding the front end
load they are paying less.
Bonds: Bonds represent a loan from the investor or bond holder to the issuer. Issuers could be the U.S. Government, a state or local
government or a corporation. In return for the loan the issuer promises to pay the investor annual payments of interest and to repay the
principal when the bond matures. These payments are guaranteed by the issuer. It is important to understand that this guarantee is only as
good as the issuer’s ability to pay. Many bond issuers have defaulted on their payments because they did not have the money to make
those payments.
Certified Financial Planner™: The leading credential in the field of financial planning. To earn the CFP® designation applicants must
complete course work in the areas of investment planning, retirement planning and employee benefits, insurance planning, income tax
planning and estate planning and pass the CFP® boards, a rigorous ten hour exam. Applicants must also complete a minimum number of
years working in the financial planning profession and adher to a strict code of ethics. There is a continuing education requirement to
maintain certification.
Churning: Churning is the practice of generating unnecessary transactions in a brokerage account in order to produce commissions for
the broker. Stocks are bought and sold at commissions of about 1%. Mutual funds are bought with sales loads of approximately 5.5%. You
may own a stock or mutual fund that has temporarily lost value. When you call your broker for advice as to how you should respond you
want to get advice that is in your best interest. Sometimes that advice is to sit tight and wait for the investment to recover. This is the
financial equivalent of bed rest and chicken soup. That may not be what you want to hear but it could be the best advice. Your broker won’t
get paid to give you that advice. You might be told what you want to hear, sell that risky investment and buy this safe investment, at a
commission of course.
Credit Quality: Bond issuers make two promises to investors, to make timely payments of interest and to repay the par value or principal at
maturity. The credit quality of the issuer speaks to their ability to keep that promise. Their guarantee to make these payments is only as
good as their ability to pay. Credit rating agencies such as Standard & Poor’s, Moody’s and Fitches examine the finances of bond issuers
and issue credit ratings to help bond investors evaluate the credit worthiness of issuers. These ratings are similar to the credit scores of
individuals. The higher the credit rating the lower the interest rate paid on the bond. Lower rated bonds pay higher interest rates to
compensate investors for the increased risk.
Dividends: These are quarterly payments to stock holders which are paid from company profits. Not all profits are paid out as dividends.
Some are reinvested to finance future growth. Profits, also known as earnings, can fluctuate from year to year. Companies prefer not to cut
dividends when profits drop because many stock holders depend on those dividends. Therefore management tends to be conservative in
setting their dividend policy paying only what they believe they can sustain in the face of fluctuating profits. In rare cases a company will cut
their dividend. This usually follows a period of declining profits or losses.
Efficient Markets: Investors buy and sell stocks and bonds based on all the known information which may impact the value of those
securities. If an investor believes a stock is worth more than the current market price he will buy that stock helping to send its price a little
higher. Another investor may believe the current market price is too high and sell the stock. Thousands of individual and institutional
investors are constantly evaluating the prospects for stocks and their collective buying and selling set the price for each stock in the
market. Some of these investors will be right while others will be wrong. The right decisions tend to off-set the wrong decisions sending the
price of each stock reasonably close to its appropriate price. The more information that is available about a stock, the more widely it is
spread, the faster it travels and the more investors that are actively trading the stock the faster that new information is reflected in stock
prices. In theory this means that most securities are selling for close to the appropriate price and it is difficult for a portfolio manager to earn
a return higher than the stock market without taking more risk. To test this theory several studies have been done comparing the returns of
professionally managed pension funds and mutual funds against an unmanaged index like the S&P 500. Large majorities of these pension
funds and mutual funds failed to match the performance of the index.
Equity: This term is used interchangeably with stock. You may hear someone refer to the equity market or the stock market.
Fiduciary: A fiduciary has a legal obligation to act in the best interest of the client. Fiduciaries are held to a high standard of honesty and
full disclosure in regard to conflicts of interest with the client and must place the interests of the client above their own.
Fee-only advisors are held to the fiduciary standard. Fee-only advisors only source of compensation comes from the fees paid by clients.
Generally fees are based on a percentage of the assets under management. As the clients account grows the advisors fee grows. The
advisors incentives are aligned with the interests of the client. Commission based advisors are compensated by commissions from the sale
of a product. Once the product is sold the advisor cannot expect further compensation unless they sell you another product. This creates
an incentive which conflicts with the interests of the client. The client must ask whether a product is being recommended because it is in the
clients best interest or because is pays the advisor a commission. Find an advisor whose incentives are aligned with your interests.
Front end load: The investor is charged the commission up front upon making the investment.
Growth Stocks: These are companies whose earnings are growing more rapidly than the overall stock market. Generally the more rapidly
their profits are growing the less they pay in dividends. Some of these companies do not pay dividends because they are reinvesting all of
their earnings to finance future growth. If they are successful the price of their stock will grow. As these companies saturate the market for
their products and services their profit growth will slow and they may begin to pay dividends.
Index Funds: With a traditional mutual fund the manager attempts to buy only those stocks or bonds which they believe will generate
higher returns than the overall stock or bond market. Unfortunately studies have shown that few professional investors are able to beat the
return of an unmanaged index like the S&P 500. The markets for stocks and bonds are relatively efficient and expenses for research and
trading commissions work against these mutual fund managers. An index fund seeks to replicate the performance of an unmanaged market
index like the S&P 500 by purchasing all of the stocks in the index in the same proportions as they are held by the index. The manager
makes no attempt to buy and sell stocks in an attempt to earn a better return than the index. There is no attempt made to buy only the best
stocks in the index and avoid the worst. The manager is content to settle for the average return of all the stocks in the index. There are
index funds which track the markets for large-cap, mid-cap and small-cap stocks as well as large, mid and small-cap value and growth
stocks. More index funds track the S&P 500 than any other index. Over the long term low-cost index funds which track this index have
earned better returns than a large majority of actively managed mutual funds.
Intermediate Term: These are bonds with maturities of from five to ten years. They pay lower rates than long term bonds and higher rates
than short term bonds. They are less volatile than long term bonds and more volatile than short term bonds. They tend to be the most
popular maturities with investors because they represent a compromise between interest rates and risk.
Investment Grade Bonds: These are bonds which have been given higher ratings by the credit agencies, above BBB for Standard &
Poor’s and Baa for Moody’s. These bonds are considered to carry a lower risk of default by the rating agencies and carry lower interest
rates than more speculative issues.
Investment Portfolio: A group of investments assembled to accomplish some investment goal. The investments contained in the portfolio
could include stocks, bonds, money market securities, real estate, precious metals and commodities to name a few. The specific
investments in the portfolio should reflect the risk/return preferences of the investor. The success of an investor should be judged by the
progress of the overall portfolio and not on its individual components. A properly constructed portfolio will usually have some individual
investments that are not doing well.
Issuer: Any organization which raises money by issuing securities is an issuer. The federal government issues Treasury bonds, your state
government issues municipal bonds and General Electric issues corporate bonds and stocks. They are all issuers.
Junk Bonds: These bonds are considered the most speculative by the ratings agencies and carry a greater risk of default. Investors
require higher interest rates to compensate them for taking these risks.
Large-cap Stocks: These are the stocks issued by the largest companies. They are very established companies which dominate their
industries. They are considered to be less risky than smaller companies because they have diversified product offerings making their
earnings more consistent. They have the financial staying power to survive an economic downturn.
Load: Mutual funds that are distributed by commission based advisors are sold with a sales charge called a sales load or load. The load
goes to the broker to compensate him or her for selling the fund. Funds sold directly to investors are sold without a sales load. These are
called no load funds.
Long Term: These are bond issued with maturities of ten years or more. They usually pay higher interest rates than bonds with shorter
maturities to compensate investors for giving up access to their money for many years. These bonds tend to be more volatile than other
maturities because investors must wait longer to receive their money.
Maturity: This refers to term of years a bond will remain outstanding before the issuer retires the bond by returning the principal or par
value to the bond holder. At maturity the investor receives the par value of the bond and the issuer’s obligation to make interest payments
ends. The issuer is under no obligation to return a bond holders principal prior to maturity. The investor can sell the bond to another
investor but is not guaranteed to receive what they paid for the bond. There is an active market for these bonds.
Mid-cap Stocks: These mid-sized companies have survived the challenges and risks associated with smaller companies yet still have the
potential to grow their earnings rapidly. They are beginning to diversify their product offerings and build financial strength. The most
successful will establish dominant positions in their industries and grow to become large-cap stocks.
Money Market Securities: Also called cash, these are essentially very short term bonds with maturities measured in days, weeks and
months. The most popular money market securities are U.S. Treasury Bills which are considered the safest short term investment available.
Mutual Funds: The principal way of managing investment risk is by holding a diversified portfolio of stocks and bonds. Many small
investors lack the resources and expertise to purchase these securities. Mutual funds offer three advantages. By pooling the assets of
many investors they allow small investors to purchase a diversified portfolio of securities. Second, they provide a professional portfolio
manager to select and manage the portfolio. Third, they hold the securities, do the accounting and issue quarterly statements.
Passive Management: Index funds practice passive management. Rather than trying to actively buy and sell stocks to earn an above
average return passive managers buy all the stocks in the index such as the S&P 500 and do not trade them. This approach saves money
on research costs and trading commissions and gives investors the average return of all the stocks in the index. The low costs associated
with passively managed portfolios give them a significant advantage relative to actively managed portfolios.
S&P 500: The Dow Jones Industrial Average is the most widely known stock market index. It was created by Charles Dow to serve as a
proxy for the stock market to be used as a benchmark by investors wishing to evaluate their stock portfolios. Containing only 30 stocks it
was not considered a good proxy for the stock market. The Standard & Poor’s 500 (S&P 500) is the stock market index most widely followed
by investment professionals. It consists of 500 of the country’s largest corporations representing a diverse cross section of the U.S.
economy with a performance history dating back to 1926. It was not created as an investment portfolio but as a measure of stock market
and economic performance. Most professionally managed portfolios of large-cap stocks measure their performance against this index. To
generate long term investment returns which beat this index on a risk adjusted basis is the holy grail of professional investment managers.
Unfortunately few do.
Short Term: These maturities run from one to five years. They pay lower interest rates and are less volatile than long term or intermediate
term bonds.
Small-cap Stocks: These are the stocks of the smallest companies in the market. Companies face the most risk in their early years. They
may be one or two product companies with an uncertain market for their products and minimal financial backing. If their products are
accepted in the market they can grow at fantastic growth rates. If not they can crash and burn just as spectacularly. Small-cap stocks are
the fastest growing stocks and the most volatile. If they are successful they will grow to become mid-cap stocks and possibly large-cap
stocks.
Stocks: Also called equities, stocks represent an ownership interest in a business. If the business is profitable, owners share in the profits
to the extent of their ownership interest. These profits may be distributed to stock holders in the form of a dividend or they may be
reinvested in the company to finance an increase in future profits. If they are successful the stock price may rise. If the business is not
profitable, owners share in the losses to the extent of their ownership interest. Dividends could be cut and the stock price could fall.
Value Stocks: These companies have earnings growth rates lower than the overall stock market. They tend to be established companies
in established industries. Because the markets for their products and services are more mature they don’t have to reinvest as much of their
earning as growth companies so they tend to pay higher dividends than the overall market.
| 9 Lowell Street, Beverly, Massachusetts, 01915-3652 - Phone 978.922.9961 - Fax 978.922.9961 Conflict Free Financial Planning, Investment Counseling & Financial Education Adam Smith David Ricardo |
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