For anyone new to investing (and even for those who are not so new) the terminology used by investment professionals can be unfamiliar and a bit confusing. When you sit down with an advisor to discuss your investment portfolio, there are several words and phrases that are likely to arise. Here is a brief primer on a few of the more common:
Individual securities can be grouped into various classes with other securities that behave similarly and that share certain characteristics. For example, stocks are one type of asset that can be grouped into the equity asset class, and bonds can be grouped into the fixed income asset class. Cash is also considered an asset class, as are commodities.
An investor’s target asset allocation represents the ideal mix of asset classes that will best fit their needs and goals. You may hear an advisor refer to a 100% equity allocation, or an 80/20 allocation, with the latter representing 80% equities and 20% fixed income. Remember, equity refers to stocks (and stock mutual funds and ETFs), whereas fixed income refers to bonds (and bond mutual funds and ETFs).
In general terms, a benchmark is “a standard or point of reference against which things may be compared or assessed.” As it relates to investing, a benchmark is an index comprised of multiple securities that, as a whole, represent some portion of the market. One of the better-known indices that is frequently used as a benchmark is the S&P 500 Index. It is comprised of the 500 largest publicly-traded U.S. companies by market value (which is equal to the number of outstanding shares multiplied by the current share price). There are hundreds of different indices, representing every imaginable corner of the investable universe. As you can imagine, not all of these indices would be an appropriate benchmark for every portfolio – you would need to choose an index (or several indices, blended together) that most closely represents the market segments in which the portfolio is invested.
The importance of an appropriate benchmark cannot be overstated. In order to properly gauge your portfolio’s performance, you must compare it to an appropriate benchmark. It wouldn’t make much sense to compare a portfolio of domestic stocks to a benchmark comprised solely of international stocks, as these two groups generally perform differently. If your portfolio is well-diversified and has a mixture of domestic and international stocks, it would be better to find two indices (one domestic and one international) and blend them together in the same proportion as the stocks in your portfolio. This is particularly important if your portfolio consists of more than one asset class, such as equities and fixed income. These two asset classes perform very differently most of the time, so it would be wildly inappropriate to compare a 60% equity/40% fixed portfolio to a 100% equity benchmark.
I’d like to make one last little point about a very little point – the basis point. One basis point is equal to 1/100th of a percent. For example, 0.05% is equal to 5 basis points (or bps, commonly pronounced “bips”). Many in the industry speak in terms of basis points, simply because it’s easier than saying, “point zero five percent.” Basis points might raise their tiny little heads when advisors are discussing mutual fund or ETF expense ratios (which are the annual fees charged to investors), as well as bond yields and dividend yields.
This is but a short list, of course. You can always run a Google search for other unfamiliar terms – just make sure the site is reputable. There are many goods one, such as www.investorwords.com. And don’t be afraid to ask your advisor to explain anything you don’t understand – we are here to help!
Sarah DerGarabedian, CFA
Director of Investment Management