Trader’s Guide 1.3- Terminology

Basic Terms

The world of investments can be a daunting place, especially for those just starting out. With so many different terms and concepts to wrap your head around, it can be hard to know where to begin. That's why in this chapter, we'll be taking a look at some of the basic vocabulary you'll need to understand the various investment vehicles out there. From bonds and stocks to options and futures, we'll cover all the key terms you need to know in order to make informed investment decisions.

But before we dive into the specific investments themselves, it's important to understand some of the fundamental concepts that underlie the world of investing. One of the most important of these is the concept of interest rates.

Interest rates refer to the amount of money that is charged for borrowing money. When you take out a loan from a bank, for example, the bank will charge you an interest rate in order to compensate them for the risk they are taking by lending you the money. Interest rates can have a big impact on the value of investments, as they can affect the cost of borrowing money and the return on investment that an investor can expect to receive.

Another key concept to understand is the role of central banks in the world of investing. Central banks are financial institutions that are responsible for managing a country's monetary policy. This includes setting interest rates and controlling the money supply in an effort to achieve specific economic goals, such as low inflation or stable exchange rates.

Now that we've covered some of the basic concepts, let's take a look at some of the specific investment vehicles you'll encounter.

One of the most common types of investments is bonds. Bonds are essentially loans that are made to governments or corporations in exchange for a fixed rate of return. When you buy a bond, you are essentially lending money to the issuer in exchange for regular payments of interest. The issuer is then required to pay back the principal, or the amount of money you originally lent, when the bond reaches its maturity date.

Stocks, on the other hand, represent ownership in a company. When you buy a stock, you become a shareholder in the company and are entitled to a share of the company's profits. Unlike bonds, which provide a fixed rate of return, the value of a stock can fluctuate based on a variety of factors, including the company's financial performance, the overall state of the economy, and even investor sentiment.

Another important term to understand is return on investment, or ROI. This refers to the profit or loss an investor realizes on their investment over a given period of time. For example, if you invested $100 in a stock and the value of that stock increased to $110 over the course of a year, your ROI would be 10%.

When it comes to investing, it's also important to consider your time horizon. This refers to the length of time you plan to hold onto an investment. If you have a long time horizon, you may be more willing to take on more risk in the hopes of achieving higher returns. On the other hand, if you have a shorter time horizon, you may be more focused on preserving your capital and may be more conservative in your investment decisions.

Yield is another key concept to understand when it comes to investing. Yield refers to the return an investor receives on their investment, expressed as a percentage of the investment's value. For example, if a bond has a yield of 3%, this means that the investor will receive 3% of the bond's value in the form of interest payments each year.

In addition to traditional bonds, there are also other types of bonds you may encounter as an investor. One of these is preferred stock. Preferred stock is a type of bond that

pays a fixed rate of return and is considered less risky than common stocks. However, preferred stockholders do not have the same ownership rights as common stockholders, and their dividends are paid out before those of common stockholders.

Another important concept to understand is the yield curve. This refers to a graph that plots the yields of bonds with different maturities. A normal yield curve is one in which yields increase as the maturity of the bond increases. However, if the yield curve is inverted, this means that yields are higher for shorter-term bonds than for longer-term bonds. An inverted yield curve can be an indicator of economic uncertainty or an impending recession.

Another key concept in the world of investing is fractional reserve banking. This refers to the practice of banks holding only a fraction of their deposits in reserve, while lending out the rest. This allows banks to create more money and can help stimulate economic growth. However, it also carries the risk of creating too much money, which can lead to inflation.

When it comes to investing, it's also important to understand the different asset classes available. Asset classes are categories of investments that share certain characteristics. Some common asset classes include stocks, bonds, and cash. Each asset class has its own unique set of risks and potential returns, and investors may choose to diversify their portfolio by including a mix of different asset classes.

Another important concept to understand is correlation. This refers to the relationship between two assets or investment classes. A positive correlation means that the two assets tend to move in the same direction, while a negative correlation means that they tend to move in opposite directions. Understanding the correlation between different assets can be helpful in managing risk in a portfolio.

One of the most well-known theories in the world of investing is modern portfolio theory, or MPT. This theory, developed by economist Harry Markowitz in the 1950s, suggests that investors can create a diversified portfolio that maximizes returns for a given level of risk. MPT is based on the idea that investors can reduce risk by holding a mix of assets that are not perfectly correlated with each other.

In addition to traditional investments like stocks and bonds, there are also a number of more complex investment vehicles to consider. One of these is options. Options are financial contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specific price within a certain time frame. Options can be used to hedge against potential losses in other investments or to speculate on price movements.

Futures are another type of investment vehicle that involves the buying or selling of an asset at a predetermined price at a specific time in the future. Like options, futures can be used for both hedging and speculating on price movements.

Finally, there are also institutional investors to consider. These are large financial institutions that invest on behalf of their clients, such as pension funds or insurance companies. Institutional investors often have access to a wide range of investment opportunities and can have a significant impact on financial markets.

As you can see, there is a lot to consider when it comes to understanding the various investment vehicles out there. While it can be overwhelming at first, with a little bit of knowledge and some careful planning, you can start building a solid foundation for your investment portfolio.