Investing for the first time? Here are 5 terms you should know

Everything you need to know

The process of investing involves a lot of jargon that can be daunting for first-timers. While the list of investing terms is endless, these five are good to start you off on.

1. Risk return, risk-return trade-off

Both risk and return are arguably the two most important concepts to understand. Seen independently, they might appear as terms we deal with regularly. But when it comes to investment, they go hand in hand. The risk return trade-off hinges on many factors such as your temperament, your priorities, your goals and so on. So someone who wants to keep their money absolutely safe and cannot deal with even a small dip in value would seek an investment that: a) doesn’t fluctuate in value; and b) offers an explicit rate of return–for example, a fixed deposit (FD) with a bank owned by the Government of India.

How does this work? The Government of India does not usually default on its obligations. Additionally, FDs come with an insurance cover up to a certain limit. So an FD with a state-owned bank could be a low-risk option. On the flip side, another investor could accept very high levels of risk betting for high returns and is hence quite comfortable with investing in the stock market. Stocks and shares don’t carry any explicit or guaranteed rate of return. Share prices rise and fall every trading day. Hence, accepting the risk in share prices in exchange for the opportunity (not guarantee) of high returns is another example of the risk-return trade-off.

2. Liquidity

The Merrriam-Webster definition of liquidity states “flowing freely like water” as the first meaning. That’s a good way to understand what liquidity means–having access to your money as easily as water flows from a tap. The investment world’s definition of liquidity is the ease with which you can sell an investment and have access to your funds, ideally at a good price. If this sounds complicated,think of the time when the stock market fell sharply in March 2020. You could liquidate your holdings and get your money in about a week’s time, even though the value you’d receive would be much lower. So stocks are very liquid compared to a house or a real estate property which cannot be sold as easily.

Furthermore, even within equities, some shares are not as liquid as others. Cash has the highest liquidity because it is accessible, exchangeable and tradeable all the time and its value does not change. You simply remove it from your wallet to buy, say, a dozen eggs. Liquidity is important because the liquidity of your investments should be in sync with your goals, and that will help you make a financial plan.

3. Compounding

Compound interest is something most of us learnt and forgot about in school. But compound interest, or simply compounding, is seeing a massive revival as more people flock to the stock markets. Compound interest is your money earning money over a period of time. There is absolutely no guarantee of this, unless you’re talking of, say, idle money in a savings account. This is because the idle money draws interest every quarter (or month, depending on your bank), and that interest also draws further interest.

Credit card debt also compounds but at a lethal pace because if you don’t pay the dues, the interest mounts up significantly. Stock prices can also compound but that depends on many factors such as the company doing really well over a long period of time. For example, Stock X is up 10 times in 10 years but Stock Y is at the same price during the same period. So if you held Stock X and didn’t sell during the previous 10 years, your money has compounded very well.

Compounding’s biggest benefit is to teach you the importance of time in investments. That’s why Warren Buffett, when asked how to make big money, had replied, “Start early. I started building this little snowball at the top of a very long hill. The trick to have a very long hill is either starting very young or living to be very old.” So the power of compounding is best enjoyed over long periods of time if you choose your investments wisely, and if you make sensible decisions with these investments.

4. Asset allocation

Spreading your investments across a variety of assets helps in managing risk,and hence return, better. Asset allocation involves spreading your investments across various classes of assets such as equity, debt and real estate. There is no single formula for an ideal mix that applies to everyone. Usually, however, experts believe that when you’re young, you have a higher capacity to take risks and hence should own a higher proportion of equity over the long term. As you grow old, you move towards very high-quality debt. This is because as your risk appetite reduces, your investments should not be very volatile and provide you with a steady stream of income. This is the basis of the famous 100- minus-age rule for asset allocation.

5. Diversification

Asset allocation is usually used alongside or along with diversification because they seem to imply the same thing–spreading your investment across categories. However, while asset allocation deals with different types of asset classes, diversification means owning different investments within an asset class. For example, within equities, you can diversify across large cap stocks and midcap stocks or across actively managed mutual funds and index funds. Similarly within debt, you can choose from a range of government bonds, debt mutual funds and so forth. For those interested in real estate, there are categories such as commercial and residential. Thus, asset allocation and diversification need to be considered together, in conjunction, while preparing your financial plan. While both terms sound similar, it’s important for you to know how to use them for your planning.

Disclaimer: None of the material in the above column should be considered as financial advice. This column is for educational purposes only. Please consult a financial advisor before taking any investment decision.

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