Investing isn’t simple – it involves lots of decision-making, from where to put your money to how to distribute your investments among different asset classes. Even learning about investing can seem challenging as financial experts often use terms you have never heard of or have a vague idea of what they mean.
Learning investment terminology before you start investing empowers you to be more confident, helps you gain clarity when digesting investment content, and ensures effective communication when talking with financial professionals such as your banker.
To help you get past the jargon, Money254 has rounded up some of the most important investing terms that often confuse beginners. Read on to find out what they mean.
Return on Investment, or ROI, refers to how much you’ll earn in profits (or expect to earn) as a percentage of your investment.
For example, if you invest Ksh100,000 in an investment product and get back Ksh110,000 (a Ksh10,000 profit), your ROI is 10%. Typically, higher ROI is associated with riskier investment. This is because risk and expected returns are related.
Risk and returns go hand in hand. The risk-return trade-off is a concept of investing that states, “an asset's potential return will be proportional to the level of risk the investor takes.”
Taking on more risk can mean potentially earning higher returns, but there's also a greater chance of losing money, including all initial capital. On the other hand, less risky investments that aren’t volatile may provide you with more secure returns, but these are likely to be low.
Assets are resources (tangible and intangible) that you own, which can provide you with future economic benefits. They can help you meet your commitments and increase your net worth. Assets can be converted to cash when needed.
Liabilities are debts and obligations that you owe other people or institutions. These responsibilities typically arise from past transactions and must be fulfilled in the future.
Your assets and liabilities affect your net worth. Your net worth is the snapshot of your overall financial well-being. It is the primary metric you use to measure how you progress financially over time. Your net worth is the difference between your assets and liabilities.
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Diversification is a risk mitigation strategy you employ when investing. It involves spreading investments across different financial instruments, industries, and several other categories with the expectation that the positive performance of some investments will offset the negative performance of others.
This principle stems from the adage, "Don't put all your eggs in one basket." Instead of investing all your money in one investment product, you invest it across multiple investments. When one investment underperforms or goes up in smoke, you are left with another to fall back on.
Dividends are the share of profit that a company distributes to its shareholders. For example, if you are in a Sacco and own shares, you may earn dividends if your Sacco makes a profit. Depending on the company, dividends may be paid periodically (i.e., every month, quarter, half-year, or year). It may also be a one-time payment or may not be paid out at all.
On the other hand, interest is the monetary charge for borrowing or lending money, and it is typically expressed as a percentage, such as an annual percentage rate (APR).
Interest is the extra amount you pay with the principal if you take a loan.
You may also earn interest when you invest in certain products such as unit trust funds, lend your money by buying bonds, or save in an interest-paying account such as that of a bank or Sacco.
Compound interest is the interest you earn on the sum of your initial principal and the interest you earned from the prior period.
In simpler terms, it is earning interest on the principal plus any accumulated interest.
Let’s illustrate it using this example: if you have Ksh10,000 and invest it to earn 5% interest each year, you'll have Ksh10,500 at the end of the first year. At the end of the second year, you'll have Ksh11,025 instead of Ksh11,000. The extra Ksh25 is your interest from the first year earning interest.
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A share is a unit of ownership in a company or an asset. Shareholders typically have a right to certain benefits, including capital gains when their shares increase in value and dividend payments when the company/asset makes money.
Bonds are basically loans that you give to a company or the government in exchange for a promise that they will pay you back your money plus interest at the end of the term. Interest may also be paid periodically throughout the loan term, with the last payment being out with the principal.
For example, you can invest in bonds by buying treasury bonds offered by the government through the CBK.
Stocks are tiny ownership units or shares in a company listed in a stock exchange such as the Nairobi Securities Exchange (NSE) or New York Stock Exchange (NYSE).
When you buy stock, you get to own a share unit of the company. If the company performs well, your stock value increases, and if it doesn’t, your stocks may lose value.
Securities refer to all tradable investment products. It is the catchall word for investments such as stocks, bonds, commodities, unit trust funds, etc., that are typically traded at a security exchange such as NSE.
This refers to profit/loss that’s made when an asset is sold for more than or less than its original purchase price.
For example, if you buy land for Ksh1,000,000 and sell it for Ksh1,100,000, the difference is your capital gains.
Capital gain/losses can also be on paper if you don’t sell the asset. For instance, if the Ksh1,000,000 land depreciated and now costs Ksh900,000, even without selling it, you will have suffered a capital loss of Ksh100,000. This is because when calculating your net worth, you will use its current market price, not the buying price.
Capital gains may attract a capital gain tax that you must pay to the government when you sell and/or transfer an asset to another party.
Liquidity refers to how easily you can convert an asset into cash without losing much value. The quicker and easier it is to turn that asset into cash, the more liquid it is.
Cash in your traditional savings accounts, mutual funds, and stocks are typically considered liquid investments. However, when an account penalises you for early withdrawal by forcing you to forfeit interest earned or charge you a certain fee, that account isn't considered liquid.
Tangible assets like real estate or gold are considered illiquid. Converting them to cash by selling them for their current market price can often take some time.
A bear market refers to a period where stock and share prices of trading securities are falling or are expected to fall, or the market is on a downturn. It typically happens during times of recession or public crisis.
On the contrary, a bull market is one where the prices of trading securities are rising or are expected to rise. Bull markets and upswings of security prices often correspond to periods of economic growth.
Market volatility refers to the degree of variation in the price of financial instruments, such as stocks, bonds, and commodities, over time. It is a measure of how much these prices fluctuate within a specific period.
Market volatility can occur in both bull and bear markets. It is characterised by occasional price spikes or rebounds in bear markets. In a bull market, the same happens when there are sharp price swings, especially when expectations and reality don't align.
Real estate investment trusts are like mutual funds that primarily focus on real estate. REITs pool funds from several investors and use the money to invest in real estate, which they operate to ensure it generates income or sells for profit.
The returns from the REITs are shared among investors as dividends. REITs are traded in the NSE, and you can invest in one by buying the minimum shares. The initial investment can be as low as Ksh1,000.
A unit trust fund is a collective investment instrument that allows investors with similar investment objectives to pool their money into a fund. Unit trust funds help small-scale investors diversify their portfolios by pooling funds from many investors and using them to invest in various opportunities in the market, such as equity, bonds, and other securities.
In Kenya, unit trust funds are governed by the Capital Markets Authority (CMA). A unit trust fund must have a trustee who safeguards the assets of the funds and a CMA-approved fund manager who manages and invests the pooled funds.
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The world of finance and investing is vast, and these are just a few of the terms you're likely to encounter on your investment journey. There are hundreds if not thousands, more waiting to be explored. As you venture into the exciting world of investing, don't be afraid to ask questions when you come across unfamiliar terms or concepts.
Remember that it's okay not to understand something at first – that's how everyone begins their learning and investing journey. The worst assumption you can make is to assume you know what a term means without verifying it.