Here we are at session number 64 , and we’re going to be talking about the core terms you need to be aware of if you’re looking at investments. Like any industry, the personal finance world is full of jargon and unique investment terms for things, so I’ll be clearing some of these up for you . That’s way you’ll be armed and dangerous when looking where next to invest.

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Introduction

When you’re thinking about investing, it can be quite bewildering to be confronted with the endless technical terms and jargon facing you. So I’m going to go through all of the terms you’ll likely come across, discard the ones you don’t really need to bother with and explain those you do need in a way which everyone can understand.

Everything you need to KNOW

Here we go with a run down of mysterious terms you’re bound to come across in your investing journey. Remember that these are terms you’ll come across when investing in funds primarily. If you insist on buying individual shares you will come across other jargon which maybe I’ll save for another session.

1 – Alpha

Investing might seem like an art sometimes, but it is more of a science in  my opinion. And like all sciences there are ratios and other measures that are unique to investing and which can really be confusing. I’m not kidding when I say that I tend to keep some of these definitions handy in Evernote so that I can refer to them if a client asks about them. This is simply because my brain can’t seem to retain them!

Alpha is one of five technical risk measures. For our purposes it can be described as the performance of a fund compared to its benchmark.

So, if a fund is investing in UK shares its benchmark may be the FTSE All-Share index. The manager of the fund is aiming to beat the performance OF the index by choosing what he or she believes are the best stocks from those available IN the index or market.

If the index rises by 5% and the fund rises by 6% the fund would have an Alpha of +1. If the market rises by 5% and the fund only rises by 4%, the fund would have an Alpha of -1.

You have heard me talk about passive funds here on the podcast before. Some stats show that only one in four managers of funds adds Alpha consistently – your job as investor is to find the right managers. Or you can invest in passive funds which have no manager and just aim to track their benchmark index.

Alpha is fundamentally a backward-looking measure. It shows how a fund/manager has done, which may or may not indicate how they might do in the future.

2 – Beta

Beta is another measure of risk, of volatility, and shows the extent to which a fund will respond to movements in the market.

A Beta of 1 means that the fund in question will move in line with the market.

A Beta of less than 1 shows that the fund is less volatile than the market and a Beta of more than 1 means that the fund is more volatile. For example if a fund has a Beta of 1.2, it is 20% more volatile than the underlying market.

Again, this measure is a backward-looking one, but it is nonetheless an important one. It can be a useful indicator of the risk that a manager is taking to achieve his returns. If you are considering investing in a fund which has performed brilliantly, you should take a look at the Beta and see what kind of a ride the manager has taken. If, in the pursuit of great gain, the fund has swung around like a roller coaster, with double-digit losses at times, then you need to ask yourself if you can cope with this kind of volatility. If so, then fine.

Beta adds context to performance numbers and is a key measure of risk and return.

3 – Standard Deviation

This is the third of our useful measures of risk, and for anyone who did statistics in maths at school, you’ll understand that this is not unique to the investing world. Standard Deviation is the extent to which a fund’s return deviates from its mean or average return.

So a volatile stock will have a high Standard Deviation and a less volatile stock will have a lower Standard Deviation. It is therefore a measure of how rocky a ride the fund has been on. The calculation of Standard Deviation involves square-rooting things which makes my eyes glaze over, but its benefit, as with all these measures is in comparing a fund with its peers.

If two funds have performed largely the same over a set period of time, and yet Fund B has a higher Standard Deviation than Fund A, then Fund B has been a riskier choice because it has fluctuated more widely in value than Fund A.

There are two other risk-measures which I reckon are beyond the scope of most investors. They are the Sharpe Ratio and R-squared. A great place for definitions on these and many more financial terms is Investopedia.

4 – Ex-Dividend

Many shares and funds pay out an income in the form of dividends. These are declared twice or sometimes four times a year. If you think about it, it wouldn’t be fair for someone to buy a fund two days before the dividend is paid out, to receive that income when that dividend has been earned over the preceding six months, say.

So at a point in time before the dividend is paid out, the fund is said to be ex-dividend. This simply means that if you buy that fund after the ex-dividend date, you will not receive the next dividend. Instead you will benefit from the dividend after that.

5 – Asset Allocation

I’ve talked about Asset Allocation before on this show. Put simply – which is the whole point – asset allocation is the process of investing your money in different asset classes in a given proportion. In other words, it’s deciding how much of your money to put into each asset.

Asset allocation shouldn’t usually be static but should be fluid. We talk about Strategic Asset Allocation which is long term and usually acts as a baseline. Tactical Asset Allocation on the other hand, is shorter term and takes account of whatever’s going on in the world right now. Both is best, in my opinion.

6 – Rebalancing

When you have set an asset allocation at the outset of an investment it will gradually get out of kilter. One asset class performs well and another one not so well. You end up with the first asset class being a larger proportion of your portfolio than it was at outset. If this gets too far out of kilter, then you can end up with a far riskier portfolio than you intended.

And so many investors undertake a program of rebalancing. Usually done once a quarter or even once a year, rebalancing resets the weightings between the assets to bring things back to how they were at the start. Many funds and platforms will do this for you automatically.

Doing it manually is a discipline as you may not feel like selling out of the higher performing asset class in order to put more back into the lower performing one. But if you’re going to do it, do it.

As usual, there’s a great article on Monevator about what rebalancing is and how to do it. – Love that site.

7 – Bid/Offer price

Mercifully, this is a term you might not need to know a few years from now. In the dark days, almost any fund you bought had two prices:

Offer Price – the price you bought the units in the fund for

Bid Price – the price you sold them for

The bid price was always lower than the offer price, so if you bought some units one day and sold them the next, you had a guaranteed loss. The difference between the two prices is called the bid/offer spread. And can be 5-6% in some cases.

Essentially it is an initial charge on the units. These days, more and more funds are single priced, which means the price is the same whether you’re buying or selling, which is far more equitable. You should avoid bid/offer spread funds where possible; there’s just no need to do that any more.

8 – Share Classes

Most funds come in different versions which serve different purposes. I’ll cover income and accumulation shares in a minute, but share classes are slightly different to that. Usually, the different share classes are priced slightly differently.

So let’s say fund share class A has an annual management charge of 1.5%. This might include a ‘trail’ commission of 0.5% to an adviser or to a platform for selling that fund.

Share class B might dispense with that extra commission and be charged at 1%. This amount might still include some extra costs, so….

Share class C might strip those out and have an AMC of 0.8%

Share class D might be only available via a pension or life assurance contract, and cost 1.2%…

And Share class E might be a ‘superclean’ version with an even lower AMC negotiated by a really big platform and only cost 0.65%

The point is that the underlying investments, the things the fund buys and sells to make money, are the same across all share classes. The different classes are there to conveniently offer different pricing on the fund to different parties or to account for different charging structures.

It does get confusing though. Obviously you should look for the cheapest version you can of the particular fund you want to buy, but you may find your options are limited by the platform you’re using or by the fact that you’re not using a platform at all.

9 – Basis Points

Basis points is a jargon term that annoys me, even though I grudgingly admit that they do have a place.

One basis point equals one hundredth of one percent. Why might this be used? Well, if we are discussing charges on funds, for example, like we were doing just now, we might say that Share class E is 0.15% cheaper than Share class C.

Another way to say it is that Share class E is 15 basis points cheaper.

Makes sense, until you understand that the financial services industry also uses the shorthand of bps or ‘bips’ to describe the same thing, as in “Share class E is 15 bips cheaper”

Now you know that, you’ll wonder how you got along without that knowledge and you can impress all your friends at dinner parties.

10 – Income/Accumulation Shares

These are not share classes as such but the difference between these two is important when understanding your annual or six-monthly statement of your investment.

The difference comes down to how they each handle the reinvestment of dividends. Shares, as you know by now produce an income in the form of a dividend. This is a distribution of profit made by the company to its shareholders. If a fund holds shares then the fund itself ‘creates’ dividends. You the investor can choose to have those dividends paid out to you six-monthly or quarterly or sometimes even monthly, or you can leave the income in the fund to benefit from compounding.

If you hold accumulation shares and they produce a dividend, the dividend is accumulated within the fund. The amount of the dividend increases the value of each unit by the given amount. So if each share is worth £10 and the dividend is 10p per share, then the shares would be worth £10.10 after the dividend. Obviously this takes no account of tax or costs and is over-simplistic but you get the idea.

Now, if you hold Income shares the dividend is spun out of the shares and can either be paid out to you or used to buy more shares. Notice the subtle difference here. Assuming you want to reinvest the dividend then you buy more shares. So now if the shares are £10 each and the dividend is 10p, you will buy one hundredth of a share for every share you currently hold.

Confused? You will be! Suffice it to say that if you hold accumulation shares, the number of shares you hold will never go up unless you invest more money yourself. Whereas if you hold income shares the number of shares you own will go up  after each dividend is declared.

Phew, let’s move into easier ground

11 – AMC/TER/OCF

These are three acronyms which describe different ways of expressing the charges on a fund.

AMC stands for Annual Management Charge and is a kind of baseline cost to you the investor for holding a fund.

TER stands for Total Expense Ratio which is a nonsense because it isn’t the total and it isn’t a ratio! The TER includes a few more costs than the AMC but still not everything, would you believe.

These days, funds tend to express their costs as the Ongoing Charge for Funds, or Ongoing Charge Figure, or OCF. This is a more complete picture of the costs of holding a fund. If a fund charges a performance fee, then it will be disclosed separately. This was included in the TER, but not always.

Sigh.

Anyway, look out for the OCF and use this figure to compare funds.

12 – Key Investor Information Documents

Back in the day, funds used to issue so-called ‘simplified prospectuses’ which would run to many tens of pages and were intended to communicate the aims of the fund, the costs, the risk and all that jazz. The problem was, they were far from simple and no-one read them and every fund house had a different format for the documents.

And so our friends in Europe actually came up with a useful set of rules called UCITS IV and introduced the Key Investor Information Document, or KIID, which everyone calls ‘kids’.

It is law for advisers and platforms to provide these documents before you invest, and you should take the time to read them carefully. They’re two pages long and include all the information you need in a standardised format – very useful.

13 – Yield/Coupon

Both these terms are fancy names for income. If a fund you are investing in is producing an income, you will see the amount of income being produced expressed as a percentage on the fact sheet and on the KIID. This will be called a yield, so for example the fund may have a yield of 3.25%, meaning that if you invest £10,000 you should expect to receive an income of about £325 per year before tax.

When investing in government and corporate bonds, the interest a bond produces is called the coupon, but this is the nominal income based on the face value of the bond. Bonds are traded on the stock market like shares and may command prices higher or lower than the nominal or face value of the bond. This affects the income when expressed as a percentage but not when expressed in money terms.

Rather than confusing the issue much further here, watch video number 282 on the website. You may never need to know terms like running yield and redemption yield if you hold government or corporate bonds in a fund, but if you’re interested, that’s the video to watch.

14 – Bond

Bond is a word which means about six different things in financial services. Well, at least three anyway.

Firstly, many people use the word bond to describe fixed-term, fixed-interest savings accounts. So you might go into Nationwide and invest in a three year bond paying 3.5%, say.

Also, the word bond is used to describe a lump sum investment with a life insurance company. You can get offshore bonds and onshore bonds, but they are both just wrappers in which you hold funds. Many people still have old With Profits bonds they bought decades ago, and which have probably served them pretty well.

Finally, the term bond is most properly used when describing the IOUs issued by governments and companies when they need to raise money. These government bonds and corporate bonds are important investments and are often grouped together under the heading of fixed interest or fixed income investments.

15 – Absolute Return

Absolute return funds have become popular in recent years, not least due to the volatile stock markets of the last 6-7 years. The idea is that an Absolute return fund will make a return no matter what the market does.

Most funds seek to outperform their peers or the market – you could say these funds are looking for a relative return, relative to their peers or to the market that is.

But an absolute return fund is looking for just that, an absolute return. Not based on anything else, just a return. To do this, an AR fund might employ techniques which other funds might not, such as short-selling, using futures and options and other complex financial instruments.

Absolute return funds have been somewhat discredited because they have largely failed in their quest for a return no matter what.

16 – Total Return

And finally let’s look at total return.

Imagine you hold shares in a fund. The value of your investment can grow in two ways:

• it can produce an income which you can spend or reinvest, and
• the value of the shares you hold can go up in line with market movements.

So you have Natural Income and Capital Gains. The combination of the two is the total return of the fund. Simples.

Summary

That is fifteen definitions of terms which can be confusing to many people when they are investing. There about 130 million more I could have chosen. It is worth mentioning here that these definitions are by necessity very cursory. There is plenty more detail to many of them which there just isn’t time here to cover. I do reckon I’ve given you what you need though.

If any of these raise further questions, leave them in the comments section below.

This week’s reviews

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Next Session Announcement

Next time we'll be talking about two Hot Topics which are very much in the news right now. One is collective pensions, announced in the Queen’s Speech this week, and the other is the decision by the ECB to reduce interest rates to negative rates. If you have a question on this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/askpete

Outro

That's it for this session of the MM podcast, I hope it was helpful. If I missed anything or if you have any questions, please leave them in the comments section below.

I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.