Ep2. Before You Invest...
Terms you have to know
If you understand what investment is, you have already achieved the half of this marathon. However, investment terminologies sometimes confuse you. “What is PER?”, “How do I calculate PBR?”, or “What the world is moving average line?”. These terms are useful to know for investment decisions, you have to understand those meanings. This time, we will look at various investment terms. These are used among investors and have important roles to make investment strategies and asset management. I will elaborate on each term later. First, let’s look at terms and simple meanings.
Terms you must know
▪ Interest rate
Interest rate is a ratio of expenses you have to pay for loans. It is changed by policies of central banks, inflation, and other economic situations. It also affects the decision of investment and loan.
▪ Risk-free interest rate
Risk-free interstate rate(or Risk-free rate) is an interest rate you can earn without any risks. Usually, coupon rates of government bonds are risk free, and it is used for reference point to compare to other investment returns. Calculating simply, investment return is a sum of risk-free rate and various risk premiums.
▪ Inflation
Inflation is a term indicating the price of goods and services increase as the time passes. Inflation decreases purchasing power and lowers real investment return in the long term. The higher the inflation rate, the lower “real” investment return.
▪ Sector
Sector is a cluster of companies that have similar characteristics or business industry. Finance, tech, and healthcare are the examples. Investors can invest across various sectors to diversify and manage risks. You can use complementary relationships among sectors for diversification.
▪ Business cycle
Business cycle is a phenomenon of repetitive contraction and expansion of the economy. It is composed with expansion, peak, contraction, and trough. Each stage influences investment decisions and market projections.
▪ Market capitalization
Market capitalization is the total market value of a company. it is a multiple of the current stock price and total number of issued stocks. It can be separated by size ; large-cap, mid-cap, and small-cap. It also shows the location of the firm in the market.
Asset class : Where should I invest?
Asset class is a cluster of assets we want to invest such as stocks, bonds, and real estates. Each class has pros and cons according to investment goals, risk tolerance, and economic cycle, so you have to learn characteristics of the classes for a better decision.
▪ Stocks.
A stock is a security for ownership of a firm. It is the most popular asset class. Normally, investors owning stocks share rights and responsibilities for profit and loss of the company. Therefore, even though you have only 1 stock of the firm, you can participate in a general meeting. Investing in stocks, you can earn capital gain from increasing value of the stocks and dividend yield. So, you should choose a proper stock after you figure out a stock’s characteristics and investment goals.
▪ Bonds
A bond is a sort of IOU for governments or companies to finance from markets. Investors receive interest income for a certain period and principle on an expiration day. There are several types of bonds, and recently, new types are appearing like hybrid bonds. Still, bonds are considered as asset classes providing stable interest income.
▪ Fund
A fund is a financial instrument to invest in various classes with capital from various investors. You can access classes you cannot invest as an individual investor, lower risks through diversification, and have professional management services. You can also invest in funds in banks or security firms, and invest according to your risk tolerance. If you are a professional investor. you are able to use private funds. It is a closed fund with less than 50 investors. It is closed so information is untransparent, but investment return is higher at the same time.
▪ ETF
An ETF is a fund that is traded in exchanges like stock, and follows indices derived from various assets. It has lots of advantages such as lower price, higher liquidity, and diversification. If you think a certain sector or asset class is promising but don’t know how to invest, I recommend you to invest in an ETF first. For instance, an ETF investing in S&P500 can be chosen when you want to invest in large-cap american companies but don’t know which companies to invest.
▪ Index fund
An index fund is a fund replicating a portfolio composed based on a certain index. It targets market average return, and is popular because of low management fees and simplicity. A passive investment usually uses the fund, and you can seek low but stable return. It is useful when market volatility is high or in depression. Specifically, it is recommended for investors whose risk tolerance is low.
▪ Derivatives
Derivatives are financial contracts whose value is determined according to the price movement of a base asset including stocks, bonds, materials, and et cetera. Futures, forwards, options, and swaps are derivatives, and those are used for risk management, investment, and even speculation. These are “contracts”, so delivering real commodities usually doesn’t happen. I introduce several types of derivatives.
- Futures
Futures are legal contracts to buy or sell an asset in a certain future. Usually it is for hedging price volatility. Contracts can be made by commodities, index, currency, or other assets. For your information, forwards are the same as futures, but it is different from futures because it is traded out of the counter(OTC).
- Options
Options are contracts to buy or sell rights to buy or sell a certain asset with a specific price in future. Investors restrain risks and make various strategies using options. There are 2 types of options, call and put.
- Hedge funds
Hedge funds are funds using various methods and targeting higher returns. Usually it takes higher risk and is for institutional investors and high net worth individuals.
▪ Alternative investments
Alternative investments mean asset classes contrast to traditional investments including stocks, bonds and cash. These include real estates, private funds, commodities, art, and et cetera and are used for variety and hedging.
- Real estate
Investing in real estates is to invest in physical assets like lands or buildings. Investors prefer the asset because of rental income, capital gain, and stability. There are 2 types of real estate investment ; direct and indirect investment. A direct investment is to invest in physical real estates. An indirect investment is to invest in real estates using securities such as REITs. Some real estates have the merit of living and investing at the same time. If you cannot earn the return you wanted to, you can live.(Of course if you can afford to pay the interest expense!)
Indicators : How can I decide whether to invest?
Indicators are tools when you decide whether to invest and when to invest. There are indicators using financial statements or charts. Normally, indicators are relative, so you should judge the indicators compared to peer groups. Absolute indicators exist too, but relative indicators are more popular, and using both is better.
▪ ROE(Return on equity)
ROE shows how efficiently the firm earns profit using equity. High ROE indicates the firm uses equity efficiently and the firm can sustainably grow. It is also useful to evaluate business performance.
▪ PER(Price-earning ratio)
PER is the divided value of a current stock price to earnings per share. It shows whether the stock price is overvalued or undervalued. For example, if the value is higher than a peer group, it is overvalued. Therefore, so-called value investors invest in stocks whose PER is lower than a peer group. However, low PER doesn’t always mean value investment, so you should analyze the reason for the low PER.
▪ PBR(Price-book value ratio)
PBR is the divided value of a current stock price to book value per share. In other words, it is a ratio for how much you can receive per share if the company is sold right now. Investors use it to evaluate a stock price and compare the price. It is also a relative indicator. Thus, you should compare it to a peer group. But sometimes it is considered as an absolute indicator. The ratio higher than 1 means the stock price is overvalued, which means extremely high PBR indicates the stock price has lots of bubbles.
▪ PCFR(Price cash flow ratio)
PCFR is the divided value of a current stock price to cash flow from operation per share. It is used for evaluating a company’s value and financial solvency. HIgh PCFR means the stock price is evaluated higher than cash flow of the company. This stock is considered impossible to grow sustainably.
▪ PEG(PER to growth ratio)
PEG is the divided value of PER to expected growth rate. This ratio shows how appropriate a company’s growth potential is compared to the stock price. It is useful to evaluate promising companies. PEG also shows a disparate ratio. The disparate ratio is the ratio showing how disparate a real value of a company and market value are. High PEG means the company is overvalued. I recommend investing in low PEG stocks if you seek stable growth.
▪ EPS growth rate
EPS growth rate shows how fast a company’s earnings per share grows. High EPS growth rate indicates the company has profit and growth potential, and can be an attractive signal to investors. Growth investors consider this rate. It is also used as a denominator of PEG.
▪ Standard deviation
A standard deviation is a statistics showing how volatile the return is from its mean value. Therefore, it is an indicator to evaluate investment risks. Normally investors use standard deviations of each class to construct a portfolio. You can evaluate a diversification of the portfolio because the portfolio’s standard deviation is a weighted average of standard deviations of each class.
▪ Beta
Beta is an indicator to measure relative volatility of a certain stock or a portfolio to a market. Beta higher than 1 means the stock or the portfolio is more sensitive than the market. For example, if the beta is 2, then the price increases 2%p when the market increases 1%p. In other words, beta is sensitivity of stocks or portfolios. For your information, a similar concept for bonds is duration.
▪ Market index
Market index is an indicator for performance of a certain market or a whole market. DJIA, S&P 500, and NASDAQ are the examples. In Korea, KOSPI 200 is an example. Investors can analyze economic or market trends using these indices. Index funds mentioned above follow the index.
▪ Moving Average Line(MAL)
MAL is a statistical tool to analyze market trends using an average of price movement. Comparing short, mid, and long-term MAL, you can acknowledge significant signals for investment decisions, especially rebounding or decreasing signals. For example, a golden cross, where a short-term MAL smashes through a long-term MAL, is a buying signal, whereas a dead cross, where the long-term MAL smashes through the short-term signal, is a selling signal. Most charts show 5-day, 20-day, 60-day, and 120-day MALs.
▪ Relative Strength Index(RSI)
RSI indicates over-buying or over-selling status measuring velocity and volatility of price increasing and decreasing. Usually RSI over 70 means over-buying, under 30 means over-selling. It is used in technical analysis, but it is relative so more useful.
▪ Moving Average Convergence Divergence(MACD)
MACD is an indicator of relationship between 2 MALs. It is used to identify strength, direction, and turning point of trends. MACD is useful to analyze market momentums.
▪ Bollinger Bands
Bollinger Bands are composed of 2 standard deviation bands located upside and downside of a MAL. The bands measure market volatility and are used to identify over-buying and over-selling signals. Personally, those are very practical indicators for technical analysis.
▪ Resistance Line
Resistance line is a certain price level that the price increases and is resisted. If the price is close to this line, selling pressure inclines and the price might be hard to increase. Also, it is considered as a potential selling point.
▪ Support Line
Support line is a certain price level that the price decreases and is supported. If the price is close to this line, buying pressure inclines and the price might be hard to decrease. Also, it is considered as a potential buying point.
▪ Relative Momentum Index(RMI)
RMI is an indicator measuring relative price movement and velocity in a certain period. Traders use it to figure out market strength and direction. Plus, it is useful to identify over-buying and over-selling.
How to invest?
▪ Income Investment
Income investment is a strategy to invest for assets earning regular incomes. It targets to earn stable interest income or dividend income from bonds, dividend stocks, or real estates. It is suitable for investors who want a retirement plan and a stable income source.
▪ Growth Investment
Growth investment is a strategy to invest for assets or companies expecting huge value increases in the future. This strategy targets high return rate, but also involves high risks. Usually it invests in tech, bio, or new industries. Most companies in those sectors give less or no dividend because they invest those capital to their growth.
▪ Value Investment
Value investment is a strategy to invest for assets considered undervalued in markets. It concentrates on long-term fundamental value of firms, and targets stable income and low risks. Warren Buffett is a good example.
▪ Reinvestment of Earnings
Reinvestment of earnings means to reinvest investment income. You can receive compound effects and increase asset value quickly. Usually investors reinvest dividends or interest incomes. Also, they reinvest capital gains. It is a significant strategy to consider as a portfolio aspect.
▪ Stock Loan
Stock loan is borrowing capital holding a mortgage on stocks you have. Using this, you can secure cash and stock ownership. However, if the stock price decreases, you might pay extra cash or repay immediately.
▪ Leverage
Leverage magnifies investment size by borrowing capital. It increases potential incomes and loss risks. It increases investment sensitivity, so you have to calculate net income rate offsetting interest expense and investment return. Leverage can be used in various investments including stocks, real estate and derivatives. The largest advantage of leverage is that you don’t need to invest your own money. It is a crucial concept, so we will see it later in detail.
What about my investment return?
▪ Yield
Yield is a ratio of investment income to principal. It includes interest income, dividend, and capital gain, and is an important indicator to evaluate investment efficiency. In a portfolio perspective, it is ideal to annualize the ratio of sum of every return. Don’t be frustrated even though it is hard. We will see it later in detail.
▪ Risk
Risk is a possibility of loss that can happen by unexpected and expected result of investment. It includes market risk, credit risk, and liquidity risk. Investors have to understand and manage each risk. Risks bring a benefit called risk premium. It is an award to take risks. Premiums are different by types of risks, so it is important to select risks based on current economic situations. Risk management methods are different based on risks, so we will learn it later.
▪ Diversification
Diversification is a strategy to invest in various assets to lower risks. Investing in stocks, bonds, real estates and et cetera at the same time, you can decrease the effects of a certain asset’s negative performance to a total portfolio. Asset classes have their own risk-offsetting methods, so diversification is a key point of long-term investment. You should understand the concept because it always pops up whenever we talk about portfolio construction.
▪ Trading Commission
Trading commission is an expense whenever you trade using financial institutions. It increases trading expenses and affects investment return. If you buy and sell too frequently, you have to pay more trading commissions, so it is the first reason you should avoid emotional investment.
▪ Capital Gain
Capital gain is a profit you earn when you sell an asset at a higher price than you bought. Conversely, if you sell it at a lower price, it is capital loss. Capital gain is a significant factor to determine investment return. Specifically, it takes the greatest portion of stock investment. But, it is irregular and unsecured. Therefore, it leads investors to greed and fear.
▪ Investment Horizon
Investment horizon is a period you are planning to hold an asset. It is separated in 3 steps ; short, mid, and long-term. It influences investment strategies, asset selections, and risk management. Like we see before, tax is affected by the investment horizon, so you should use the horizon to lower your tax expense.
▪ Volatility
Volatility is an indicator to show the movement spectrum of asset prices. It is also an indicator of investment risks. High volatility stands for high price fluctuation, and means high investment opportunity and loss possibility. Standard deviation is a similar concept to volatility.
▪ Yield Curve
Yield curve is a graph of investment return rates of bonds with different maturities. Normally, long-term bonds provide a higher rate than short-term bonds. A shape of the graph shows the economic forecast and base interest rate policy.
▪ Dividend
Dividend is a cash or stock that companies provide for stockholders. Usually, mature firms with stable sales provide it, and it is an income source of investors.
Now, we learn tons of terms. Is it difficult? Don’t worry. You don’t need to know all the terms at first glance. However, the important thing is you start, continue and experience investment.
Opportunities of investment are open to everyone, and knowing terms is to hold a key to open the door. From now on, you hold the key. You step farther than people who don’t know the terms, so let’s keep moving!
