To celebrate Financial Literacy Month, our strategists share the frequently misunderstood terms all investors need to know.
School is never really out of session for investors. Many probably entered 2021 with little knowledge of meme stocks, but now we can’t forget how retail investors banded together to send certain shares soaring. But whether we’re dealing with new terms like meme stocks (stocks that typically trade on hype instead of fundamentals) or older ones like tracking error, there can be plenty of confusion around the language of investing. That’s why we’ve gathered some frequently misunderstood concepts to share with you during Financial Literacy Month.
Portfolio terms Excess return This captures the difference between a portfolio’s return and the market rate of return, and it helps investors gauge the performance of their investments compared with a benchmark. It’s calculated by subtracting the return of the portfolio from the total return percentage of a benchmark or another investment. Positive excess return indicates an investment’s performance is greater than the benchmark, while negative excess return indicates the investment underperformed.
Tracking error This is formally defined as the standard deviation of a portfolio’s excess return, relative to its benchmark, from its average excess return. If the average excess return is zero, then tracking error is the dispersion of the excess portfolio return compared with its benchmark. It’s typically expressed both as an annualized number and as a percentage. For example, we could say a portfolio has a tracking error of 1% per year. For a portfolio with a normal distribution of excess returns, average excess return of zero, and an annualized tracking error of 1%, we’d expect its return to be within one percentage point of its benchmark return approximately two out of every three years. Although investors trying to capture market beta tend to want to minimize tracking error, higher tracking error may be an acceptable trade-off in certain circumstances, particularly to achieve greater tax efficiency or meet ESG incorporation goals. (More on ESG below.)
After-tax return This may be expressed as the difference between an investment’s beginning market value and its ending market value, plus any dividends, interest, or other income received, minus the cost of taxes paid. For tax-managed portfolios, the after-tax return can be greater than the pretax return. Tax losses realized during the measurement period count as a tax benefit because they help reduce current or future tax costs.
Benchmark This is a standard used to analyze the relative risk and return of a portfolio. A benchmark needs to appropriately reflect the portfolio’s investment style and strategy and the investor’s return expectations. For instance, the S&P 500® Index may be an appropriate benchmark for a portfolio that holds large-cap US stocks, while the MSCI Emerging Markets Index may be an appropriate benchmark for a portfolio invested in emerging-market stocks.
Volatility This is a statistical measure of the dispersion of returns for a security or market index. Assets deemed to be highly volatile are viewed as higher risk because their price can change drastically over a short time and may be subject to sudden and sharp movements. Lower-volatility assets are seen as a lower risk because their price tends to remain steadier and more predictable. However, volatility at the index or individual security level can create opportunities for investors, especially when it comes to tax-loss harvesting.
Fixed income termsBid-ask spread The bid price is the price at which a dealer is willing to buy a bond, while the ask price is the price at which the dealer is willing to sell a bond. Spreads between bid and ask yields tend to be smaller for liquid bonds and wider for more illiquid ones. In short, the bid-ask spread captures the transaction cost for buying or selling a bond.
Spread over Treasuries This is a better way for investors to determine whether the market is near a top or bottom or what type of price they can get on a bond. If the market is going up, the spread between the bond and Treasuries will narrow. If the market is going down, it will widen. Investors typically seek to sell at the narrowest spread over Treasuries.
Amortization and accretion Investors typically buy a bond at a price either above or below its face (or par) value. Buying a bond over face value means the investor has purchased it at a premium, while purchasing it below face value means they’ve bought it at a discount. To spread a bond’s gains or losses over the life of the bond, investors use amortization and accretion calculations to adjust the bond’s cost basis from the purchase amount to the expected redemption amount, avoiding the need to recognize the bond’s entire gain or loss in the redemption year. With amortization, the face value of the bond is paid down regularly along with interest expense. Accretion captures the accumulation of the additional income an investor should receive after buying a bond at a discount and holding it until its maturity.
Yield to maturity (YTM) This can be thought of as a bond’s total return. It captures the total return an investor would receive if they buy the bond at the market price and hold it until maturity, assuming all coupon and principal payments are made on time. It’s often quoted in terms of an annual rate, and it may differ from the bond’s coupon rate. Investors can calculate a market YTM, which uses the current market price, or a book yield, which uses the book price. Over the life of a bond, its yield will diverge from its purchase YTM as interest rates rise and fall. When rates rise, YTM will rise. When rates fall, so too does the YTM. But investors who buy a bond and hold it until maturity can expect to receive their purchase YTM at the end of the bond’s life.
This typically refers to investments made with the intention of generating measurable social or environmental benefits in addition to financial return. An important concept in impact investing is additionality—the idea that the benefit wouldn’t have occurred absent the investment. Many in the investment world still use the term in its technical sense and reserve it for private or fixed income investments in which it’s easier to prove additionality.
According to the United Nations’ Principles for Responsible Investment, this is a strategy and practice to incorporate environmental, social, and governance (ESG) information in investment decisions and active shareholder ownership (see below). Responsible investing tends to be defined as focusing on priorities from a risk and return perspective, unlike socially responsible investing, which has been associated with ethical or values-based priorities. However, many in the investment community use these terms interchangeably.
This refers to the practice of considering ESG issues when building a portfolio—which securities should be included and how they should be weighted. One of the most common techniques is the use of screens. ESG screens allow investors to identify which companies are eligible for investment based on information such as environmental stewardship, labor standards, human rights, or basic governance practices. Another technique is integration, initially a term reserved for fundamental analysis where ESG information was used to adjust the forecasted financials. However, it's now also used to refer to quantitative techniques in which the ESG information is used to reweight portfolio constituents without any stock-level analysis.
Active ownership This term covers proxy voting, direct engagement, and shareholder resolution filing—activities intended to harness investors’ ownership rights to influence the behavior of the companies they own. According to the PRI, it’s one of the fastest-growing responsible investment strategies in listed equity globally. It’s commonly viewed as a proxy for “impact” in listed equity. This is because investors usually transact on the secondary market and don’t typically fund new ventures. This makes it harder to achieve additionality through the purchase of shares alone.
New investing terms Cryptocurrency
Also called crypto, this is an encrypted form of currency that investors buy, sell, and trade virtually across decentralized digital ledgers known as blockchains. The best-known form of cryptos include Bitcoin, Ethereum, and Ripple. Unlike other currencies, cryptocurrencies aren’t issued by centralized monetary authorities.
These are units of equity worth less than one full share, resulting from corporate actions such as stock splits and mergers. Unlike full shares that trade on open markets, fractional shares are bought, sold, and traded through brokerages. Some brokerages split full shares on their own to make them more affordable for retail investors.
Meme stocks These are stocks that see dramatic spikes in trading volume as a result of online trends, typically resulting in temporary periods of overvaluation. Meme stocks are especially popular among younger and less experienced investors.
The bottom line For both new and experienced investors, knowing the language can make a world of difference to the success of a long-term investment plan. April may be the official month of financial literacy, but investors should commit to staying informed all year round.