It's been a tough year for many of you and it's a good time to acknowledge all we have to be thankful for. Personally, I'm thankful for many things, including the trust you place in me as your financial planner. So, from my family to yours, Happy Thanksgiving.
Last week we discussed how one of the main impediments to increasing investor transparency is how complicated the financial services industry is. A big part of this has to do with jargon.
Every industry has its own language, but finance, perhaps along with medicine, has the added distinction of being dangerous if you don't understand the lingo. One of my jobs, so far as I see it, is educating you about the terms, themes, and jargon that's most important to your financial health over time.
Without basic knowledge it's hard to know what questions to ask and if the answers you're getting are sufficient, leaving you open to missteps or even fraud. In other words, what you don't know can hurt you.
While everybody's knowledge level is different, it's helpful to get a sense for where we are as a country. Earlier this year research firm YouGov surveyed about 1,200 American adults to gauge awareness of 35 financial terms.
Folks have a decent understanding of fundamental terms like "Savings Account", "Net Worth", "Asset", and "Liability", with over 70% of respondents reporting confidence about those terms. But the numbers are almost reversed for terms like "Index Fund" and "Amortization", with 60-70% reporting being uncomfortable with, or having no knowledge of, the terms.
These terms, and the others on the YouGov list (see the link below), are essential to one's financial health. Accordingly, over the next several weeks I'll be starting at the bottom (the least understood terms) and choosing a couple or so to define and comment on. Yes, you could easily look these terms up in Google, but I'll attempt to give you the real-world-financial-planner definition. Hopefully this will provide some clarity and increase your understanding.
Index Fund – Have you ever heard the news reporting the market's performance ("...in market news, the Dow was up 500 points today...") and thought, "Why can't I just invest in that"?
Well, that's basically what an index fund does. It's a fund that seeks to mimic the performance of a market index like the Dow, the S&P 500, and so forth. The managers of the fund do this by either buying stocks in the same proportion as the index, or perhaps by using other statistical methods. You can find funds mimicking all sorts of stock indexes, bond indexes, even commodities.
Transparency is increased because it's easy to see what the fund owns on any given day. Index funds are also cheaper for the fund company to manage and this is passed on to investors in the form of lower annual costs (the savings is buried in the fund but shows up as better long-term performance, all things considered).
Mimicking an index's performance works on the upside and the downside. If the Dow is down 5%, the index fund wants to be down 5%. In fact, fund managers can get fired if their performance deviates too far from the target index, even if that means they did better when the market is down.
Amortization – This is the process of spreading payments out over a certain period versus paying 100% cash up front. It could be a car, a house, basically anything you buy where there's a set schedule of payments.
Assuming you don't have a large stash of cash available to buy a house outright, for example, you must spread the payments over time. A lender is going to front you the money to buy your home, but they have to wait to get paid back, often over many years. This represents a risk for the lender, so they charge you interest as compensation.
Your purchase price is divided over a fixed period, say 360 months, and interest for the lender is added in. You'll pay the same amount each month but most of your initial payments go toward interest, which benefits the lender. This will flip over time as more of your payments go toward paying back the loan. If the loan is "fully amortized" your very last payment will zero out what you borrowed and make your final interest payment to the lender.
You can make the amortization schedule work for you by paying extra principal each month. This saves you interest expense over time and gets the loan paid back sooner. The catch is you should only do this after you're fully funding your retirement accounts. Why? Ask me and I'll explain.
Variations on this theme include "negatively amortized" loans where you pay less than the fully amortized amount each month. The interest and principal you didn't pay gets added to your balance. This is like credit cards when you carry balances over each month and only pay the minimum due – your debt just grows. Buying an expensive asset (a house, for example) this way is generally a horrible idea and should be avoided like the plague. It also contributed to the housing collapse during the Great Recession... but I digress.
Hopefully this helps you understand these fundamental finance terms a little better. If you have questions, please don't hesitate to ask.
Here's a link to a summary of the YouGov report...
Have questions? Ask me. I can help.
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