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  • William Seah

A Glossary of Investment Terms for Beginners: Part 1



There are many terms that are being thrown out there, and oftentimes, the terms have specific meanings that are not consistently understood. I decided to write a bit on some of the terms in order to bring clarity to the issue of finance. In Part 2, you can look forward to understanding the finer differences between different investment types.


(Note: The ideas here may also apply to stocks and bonds, but nothing in this article serves as advice to act or not to act. Please seek professional advice before committing to any action or inaction.)


Glossary

  1. Stock vs Fund vs Index

  2. Dollar Cost Average (DCA)

  3. Annualised Returns

  4. Risk

  5. ‘Past performance is not indicative of future performance’

  6. Unit Trust and Exchange Traded Funds (ETF)

  7. Diversification


Stock vs Fund vs Index


Stock

A stock (sometimes called, a share) represents ownership in the company. When you buy a stock, you essentially own a portion of the company (depending on how many shares you buy), and you invest in the company. You believe in the company, hence you buy a share of the company. In some cases, you will have certain rights to that share, including voting on what the company can do.


Fund

A fund is usually sold as a Unit Trust or Exchange Traded Fund (see below for a more detailed discussion on Unit Trusts and Exchange Traded Funds). It is a collection of stocks, and buying into one essentially allows you to invest in different companies.


Index

An Index is probably the most interesting of the three. In any stock market, be it Singapore or America, everyone would like to measure the stock market. The problem is you have thousands (or tens of thousands) of companies in the stock market, and it is difficult to measure the performance of EVERY company. What the index does is it tries to take a sample of the stock market and attempts to give a snapshot of the entire market. In most cases, the index will measure the performance of the largest companies, such as the S&P 500, which measures the performance of the largest 500 companies in the US, or the Straits Times Index (STI), which measures the performance of the largest 30 companies in Singapore. How these ‘largest’ companies are determined, or how to measure the performance involves heavy mathematics, and the index gets updated from time to time. Critically, the data gets simplified to a number, and it is used as a proxy for how the market has performed.



Dollar Cost Average (DCA)


What it actually means: You buy into a fund regularly. This strategy avoids the difficulties in timing the market and making rash decisions. It focuses on allowing you to average out your costs over time while staying invested in the long run.


When the prices come down, you are buying regularly in order to average out your costs (lower prices mean you buy the fund at a cheaper price).


When the prices go up, you are buying regularly, and now your costs go up. However, you continue to buy into the fund because you believe in the long-term viability of the fund. DCA is a disciplined approach that prevents us from overreacting to price signals. So by the rules of the strategy, you should continue to buy even when prices go up or down.


Application: This is a strategy that takes the psychology of fear out of the equation. It also helps people build discipline in investing, by setting aside an amount regularly to invest. Finally, it reduces money idling around earning limited interest. You’d normally use it to buy into a fund, and not into a stock.


Annualised Returns

What it actually means: This is often reported in the news or in any fund advertisement. You would see it splashed out as Fund Performance: X% per year (annualised) over the last few years. It does not mean that the yearly returns were X%. What it means is that if you had held your investment for the period in question, you would have gotten the stated annualised return. Take a look at the table below. This is the S&P 500, a stock market index of the American Stock market.




Taken from Investopedia.com


The table shows the annual return of the US S&P 500. Assume you invested $10,000 at the start of 2000. Had you held on to your investment from 2000 and sold off only at the end of 2021, your $10,000 would have grown to $48,617, more than 4 times your initial investment, for doing nothing. This is equivalent to your $10,000 earning 7.45% per year over the 22 years.


But that 7.45% was not a return for every year. If you had invested $10,000 in 2000 and sold it in 2009, you’d be left with just about $9,000. You would have lost money. Holding on for a longer period of time though would have seen you recover the losses and go on to make tremendous gains.


In English: A yearly return of x% doesn’t mean you get x% every year; but if you held it throughout the entire period, you will have the same outcome as though the fund returned x% per year. In fact, over a shorter period of time, the fund would likely have returned a vastly different return than the annualised return. In investment, you’ll often see this phrase.


Application: Returns tend to even out over time. We are now in a bear market (basically falling stock prices); if you pull out now you will realise your losses now. Over time, markets have a tendency to go up, as markets create value.



Risk

What it actually means: In investment, this is usually the standard deviation of a fund or a stock. It is calculated based on past performance; an average return is determined, and the data set is analyzed to see how FAR the data spread. The wider the range of returns, the higher the standard deviation (and hence, risk). We sometimes use the term volatility to refer to risk as well.


So if you had a fund, or a market that returned an average of 5% with a risk of 10%, that meant that in any given year of the available data, that return could be between -5% and 15%, and it is still well within expectation.


In English: it is the range of values that the track record of the fund has. A higher risk (also known as higher volatility) means that the fund values fluctuated quite a bit. A larger risk means you are more likely not to achieve the average return and might do better or worse.


Application: if you do not like to see huge swings in your portfolio values, you would probably want to avoid funds or stocks with high risk. Clearly the larger the risk, the higher the potential for returns, and for losses as well. Do note that the data is always based on available information. It does not predict future outcomes, though in general, stocks tend to be more volatile (i.e. higher risk, higher standard deviation) than bonds, and a diversified fund (holds more companies) tends to be less volatile (i.e. lower risk lower standard deviation) than a concentrated fund (holds fewer companies). Do note that lower risk does NOT mean low risk.


Past performance is not indicative of future performance


What it actually means: exactly as it says. Just because a fund has an annualised return of 10% over the last 50 or even 100 years, doesn’t mean it will continue to perform. Likewise, a fund with a negative annualised return does not mean it will continue to lose money.


In English: The available data provides information on how the fund is performing. It should not be taken to mean that this is the expected performance moving forward.


Application: Be careful with the idea of a track record. While it can be helpful as a screening tool, one should always remember that data and analysis are backward-looking. In fact, I would suggest you look at the standard deviation (or the risk) as the volatility should inform you of whether the fund suits your risk profile.


Unit Trusts and Exchange Traded Funds


What it actually means: While there are exceptions, for the most part, both Unit Trusts and Exchange Traded Funds (ETFs) are collections of different stocks. Both operate with specified strategies. ETFs are usually, but not always passively managed; they follow an index. A unit trust is usually, but not always, actively managed; the fund manager has a certain strategy in mind. ETFs are usually, but not always, low cost and unit trusts tend to be higher cost, though low-cost versions exist.

the


​ETF

Unit Trusts

Investment option for individuals

Has a fund manager

Collection of different stocks

Stocks can be from different countries

Sold on stock exchange

X

Taxed

X*

X*

Figure 1: Quick summary of the similarities and differences between ETFs and Unit Trusts


Similarities between ETF and Unit Trusts

  1. Both are possible investment options, and both can be called Funds.

  2. Both are managed by a fund manager, which is a company, or a person, who decides what to buy.

  3. Both will hold a collection of different stocks (and sometimes bonds and other investment tools)

  4. Both can hold stocks from different countries, or even different instruments

  5. Both have passively and actively managed strategies.

  6. If they are passively managed, they follow an index. This is where the phrase “buy into the market” comes from. We call it passively managed because the fund manager merely buys whatever shares are in the index.

  7. If they are actively managed; the fund manager has a certain strategy in mind. We call this actively managed because the fund manager analyse each stock based on a framework before he decides whether to buy or not. For the most part, the fund manager using this strategy seeks to beat the index.

  8. There are actively managed ETFs and Unit trusts. There are also passively managed ETFs and Unit Trusts.

  9. Generally, passively managed funds will be cheaper while actively managed funds will cost more.


Differences between ETF and Unit Trusts

  1. ETFs are sold on a stock exchange, such as Singapore Stock Exchange or the New York Stock Exchange. You buy it from someone else who is selling their ETFs.

  2. Unit trusts are sold directly to you via a platform or a broker.

  3. For the most part, ETFs are passively managed, while unit trusts are actively managed. But there are many exceptions.

  4. *Tax treatment for ETFs will depend heavily on where the ETFs are from. For example, you are required to pay taxes on dividends if you bought ETFs from America. Unit trusts typically will not attract taxes. That said, there may be other taxes applicable (e.g. capital gains) if the country you are from imposes such taxes. This is true for both ETF and Unit trusts. Speak to a tax consultant.


In English: Two commonly available tools to help people get affordable access to a collection of stocks, possibly across countries and industries as well.


Application: These are actually merely vehicles to use to invest. There is no ‘better’ tool until you are able to ascertain your own risk profile and desired outcome.


Diversification


What it actually means: A strategy of holding instruments that allows you to limit your exposure to any specific area or asset. This limits your risk of a negative event impacting your portfolio. More strategically, you need to find assets that are either negatively or un-correlated to each other. In other words, for any specific event, will the assets move in the same way? If so, that is not a diversified portfolio. For example, buying just bank stocks, even if they are different banks, doesn’t make for a diversified portfolio because any negative impact affecting the banking sector will reverberate through your portfolio greatly.


In English: Buying different instruments that are unrelated to each other, as far as possible, in order to spread out your risk.


Application: With respect to stock portfolios, this is easily done using unit trusts or ETFs. It can be costly and difficult to create a diversified stock portfolio on your own, so a unit trust or an ETF gives access to multiple stocks with just one instrument. From a total financial portfolio perspective, this means holding different instruments, such as endowments, fixed deposits, and cash savings. A proper portfolio will hold different instruments to help achieve your overall goals.


One last note: concentration builds wealth, diversification preserves it. This is a common phrase, and you realise it is the combination of ideas here. Concentrated portfolios tend to have greater volatility, which gives it a greater opportunity to earn higher returns. However, diversified portfolios tend to have lower volatility, which tends to fall less. As a result, the saying is somewhat applicable. At the end of the day, we live in a world full of tradeoffs; no instrument can achieve all your desired outcomes. Something has to give.


A proper financial plan will consider all your needs and your traits before a solution can be designed.


I hope this educational piece helps. Over time, I will continue to build on this to help my readers learn a bit more about the various terms we use.


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