Guide to Financial Literacy: Essential Finance Terms to Know

In this blog, you’ll learn essential finance terms you might come across when running your business or dealing with accountants and financial services.

Why Financial Literacy Matters

Increasing your financial literacy is important, especially if you’re just beginning your journey in finance. Whether you’re opening your first bank account or just trying to make sure you’re well equipped with knowledge, there are certain concepts that all beginners should learn.

Asset Allocation

Asset allocation refers to how you choose to spread your money across different investment types, also known as asset classes. These include:

  • Bonds: Bonds represent a form of borrowing. When you buy a bond, typically from the government or a corporation, you’re essentially lending them money. You receive periodic interest payments and get back the loaned amount at the time of the bond’s maturity—or the defined term at which the bond can be redeemed.
  • Stocks: A stock is a share of ownership in a public or private company. When you buy stock in a company, you become a shareholder and can receive dividends—the company’s profits—when they are distributed.
  • Cash and Cash Equivalents: This refers to any asset in the form of cash, or which can be converted to cash easily in the event it’s necessary.

Diversification

  • Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.

Compound Interest

  • This refers to “interest on interest.” Rather, when you’re investing or saving, compound interest is earned on the amount you deposited, plus any interest you’ve accumulated over time. While it can grow your savings, it can also increase your debt; compound interest is charged on the initial amount you were loaned, as well as the expenses added to your outstanding balance over time.

Risk Tolerance

  • Risk tolerance is your ability and willingness to stomach a decline in the value of your investments. When you’re trying to determine your risk tolerance, ask yourself how comfortable you will feel maintaining your positions when the stock market is experiencing large declines.

Volatility

  • Risk tolerance is your ability and willingness to stomach a decline in the value of your investments. When you’re trying to determine your risk tolerance, ask yourself how comfortable you will feel maintaining your positions when the stock market is experiencing large declines.

Bear Market

  • A bear market is a downward trend in financial markets, indicating a weakening economy and a loss of investor confidence. Generally, a market is considered a bear market when prices have declined more than 20%. Bear markets can be as short as a few weeks or as long as a several years.

Bull Market

  • A bull market happens when stock prices have gone up 20% or more from the previous low for a sustained period.
    • The terms “bull” and “bear” markets come from imagining actual bulls and bears. Investors started using these terms in the 1700s. There are a few theories for how these terms came about. A charging bull gives the image of confidence. If a bull attacks, it also thrusts its horns upward, matching the rising trendline of a growing financial market.
    • If a bear attacks, it swipes its claws down, representing the downward spiral of crashing markets. Another theory is that a bear hibernates, representing a market that has lost its drive and is no longer active.

Liquidity

  • Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. The most liquid asset of all is cash itself. Consequently, the availability of cash to make such conversions is the biggest influence on whether a market can move efficiently.
    • The more liquid an asset is, the easier and more efficient it is to turn it back into cash. Less liquid assets take more time and may have a higher cost.

Equity

  • Equity, often called shareholders’ equity or owners’ equity on a balance sheet, represents the amount of money that belongs to the owners of a business after all assets and liabilities have been accounted for. Using the accounting equation, shareholder’s equity can be found by subtracting total liabilities from total assets.

Dividend

  • Dividends are the distribution of a company’s earnings to its shareholders. Dividends comprise a portion of the company’s profits and are typically paid on a quarterly basis to all qualified shareholders.

Capital Gains

  • A capital gain is an increase in the value of an asset or investment above the price you initially paid for it. If you sell the asset for less than the original purchase price, that would be considered a capital loss.

Index Fund

  • An index fund is a type of mutual fund or exchange-traded fund that aims to mimic the performance of an index, such as the S&P 500®.
    • Index funds tend to offer investors lower costs and taxes than some other types of funds. They’re also relatively lower maintenance.
    • One drawback could be that investors cannot pick and choose individual investments that comprise an index fund.

Mutual Fund

  • Mutual funds are pooled investments managed by professional money managers. They trade on exchanges and provide an accessible way for investors to get access to a wide mix of assets that are selected for the fund.

Inflation

  • Inflation is a gradual loss of purchasing power that is reflected in a broad rise in prices for goods and services over time. 

Yield

  • The yield of a stock, bond, or other asset is the earnings generated and realized on an investment over a particular period, including the interest it earns, or the dividends paid to investors.
    • Yield is a measure of the profit that an investor will be paid for investing in a stock or a bond. It is usually computed on an annual basis, although it may be paid quarterly or monthly. 

Return on Investment ( ROI)

  • Return on Investment is a simple calculation used to determine the expected return of a project or activity in comparison to the cost of the investment, typically shown as a percentage. This measure is often used to evaluate whether a project will be worthwhile for a business to pursue.
    • ROI is calculated using the following equation: ROI = [(Income – Cost) / Cost] * 100

Fiduciary

  • Fiduciaries are persons or organizations who act on behalf of others and are required to put clients’ interests ahead of their own.

Estate Planning

  • Estate planning refers to the preparation of tasks that manage an individual’s financial situation in the event of their incapacitation or death. This planning includes the bequest of assets to heirs and the settlement of estate taxes and debts, along with other considerations like the guardianship of minor children and pets. Most estate plans are set up with the help of an attorney experienced in estate law. Some of the steps include listing assets and debts, reviewing accounts, and writing a will.

Tax- Deferred

  • Tax-deferred accounts such as a traditional IRA or traditional 401(k) allow you to postpone paying taxes until you begin making withdrawals. 
    • Types of tax-deferred Investment accounts: Traditional IRAs, Retirement plans such as a 401(k) and 403(b), Fixed deferred annuities, Variable annuities, I Bonds or EE Bonds, Whole life insurance

401(K)

  • 401(k) is a retirement savings plan that lets you invest a portion of each paycheck before taxes are deducted depending on the type of contributions made.
    • Because of 401(k) tax advantages, the federal government imposes some restrictions about when you can withdraw your 401(k) contributions.

 IRA (Individual Retirement Account)

  • An individual retirement account (IRA) is a tax-advantage investment account designed to help you save toward retirement. IRAs are one of the most effective ways to save and invest for the future. They allow your money to grow on a tax-deferred or tax-free basis, depending on the type of account
    • Types of IRAs: Traditional IRA, Roth IRA, SEP IRA

Expense Ratio

  • An expense ratio is the cost of owning a mutual fund or ETF. Think of the expense ratio as the management fee paid to the fund company for the benefit of owning the fund.

Asset

  • Assets are items you own that can provide future benefit to your business, such as cash, inventory, real estate, office equipment, or accounts receivable, which are payments due to a company by its customers. There are different types of assets, including:
    • Current Assets: Which can be converted to cash within a year
    • Fixed Assets: Which can’t immediately be turned into cash, but are tangible items that a company owns and uses to generate long-term income

Liability

  • The opposite of assets, liabilities are what you owe other parties, such as bank debt, wages, and money due to suppliers, also known as accounts payable. There are different types of liabilities, including:
    • Current Liabilities: Also known as short-term liabilities, these are what’s due in the next year
    • Long-Term Liabilities: These are financial obligations not due over a year that can be paid off over a longer period.

Net Worth

  • You can calculate net worth by subtracting what you own, your assets, with what you owe, your liabilities. The remaining number can help you determine the overall state of your financial health.

Final Thoughts

By familiarizing yourself with these key financial terms, you’ll not only enhance your financial literacy but also gain the confidence to make informed decisions about your personal or business finances. Whether you’re navigating investments, managing risks, or planning for the future, having a strong grasp of these concepts is essential to your financial well-being.

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