Cutting Through the Financial Jargon
Derivatives. Futures. Single premium immediate annuities. Common stock. Preferred stock. Government bonds. Corporate bonds. Commodities. REITs. Options. Swaps. Short sales. P/E ratios. Dividends. Net profit margin. Exchange rates.
Welcome to the world of financial jargon.
Investopedia.com’s dictionary includes 14,688 definitions, ranging from “abnormal earnings valuation model” to “zero coupon inflation swap.” The lingo is thick and daunting, oftentimes serving to dissuade average folk from entering the financial world with their hard-earned money. The brazen can quickly fall in neck deep, taking risks based on random blurbs in Forbes magazine, while the more cautious of us can feel so unprepared that financial advisors are the only option to navigate the complex terrain. It’s no wonder so many people dip their toes into the financial markets and get burned.
You don’t have to pass a Series 7 exam to navigate the financial markets. It’s similar to how you don’t have to know the intricacies of exposure compensation and image stabilization to take a quality photograph and how you don’t have to know the culinary difference in deglazing versus making a roux to be able to put an edible meal on the table. It equates to any field in your life. Understand your ability level, don’t overextend yourself and be confident in your decisions. Everything else is just details.
So where do we start? Let’s establish a baseline in saying that inaction is not an option. The volatility of the stock market over the last 15 years has some content with stuffing their savings in money market accounts earning one percent (or less), which is the modern equivalent of digging a hole in the ground in your backyard. Why, you ask? Inflation. A product that cost $10,000 in 2004 would cost you $12,600.90 in today’s dollars. The problem is that had you invested that $10,000 in a savings account at one percent in 2004, your value would only increase to $11,051.25 today. Your buying power decreases if you are unable match or surpass the rate of inflation.
Inflation is relatively tame in our current economic climate with costs increasing just 1.7 percent over the last 12 months, according to the Bureau of Labor Statistics’ most recent report. Even so, good luck finding a savings account interest rate anywhere close to 1.7 percent.
If action is our plan, then education is our first step. The financial services industry, by and large, is banking on your lack of knowledge in order to push a variety of products that you don’t need with costs that you can’t afford. That’s not intended as an overarching generalization of the entire industry. I have family members and close friends working in wealth management jobs designed to help individuals with significant assets diversify and protect their wealth through various means. The bulk of the middle class, however, doesn’t have enough assets to afford such levels of financial assistance. All we need is cheap access to the stock market without a levy of fees attached.
Individual stocks and bonds are far too volatile for anyone’s nest egg, but if we can put hundreds of stocks together to replicate a sector of the market or the entire market as a whole, then we’re incredibly diversified. That’s what a mutual fund is – a collection of stocks or bonds in a fund owned mutually by a large group of people. There are roughly 7,500 mutual funds available to investors, yet a NerdWallet study last year found that only 24 percent of actively-managed mutual funds beat the market index (the market as a whole). Making matters worse is that the active managers of the funds charged average fees of 1.07 percent.
“The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.”
– Jack Bogle, The Little Book of Common Sense Investing
Enter Jack Bogle. The Vanguard founder has long criticized our financial system for putting up none of the capital – that’s what you and me are for – yet receiving a healthy percentage of any profit.
His answer back in 1975 was index funds, which are investment vehicles that mirror various indices, such as the S&P 500. Since there’s limited management needed to mirror an index, the corresponding fees are significantly lower. The NerdWallet study found the average index fee to be 0.15 percent. If you think the 0.92 percent differential is not that significant, consider that $10,000 invested in an average index fund earning an 8 percent return over 20 years will grow to $47,821.35, while that same $10,000 earning the same 8 percent return in an average mutual fund will grow to $39,829.12. That fee differential of less than one percent just cost you $8,000.
And as bad as 2008 was for stocks, the S&P 500 index fund (SPX) has returned an annualized rate of 5.71 percent over the last 10 years. Bogle disciples, otherwise known as bogleheads, have even offered simple two-to-three fund portfolios to minimize costs while effectively outpacing inflation.
Don’t expect any big fish stock stories to tell your friends about over drinks, however, by going the index fund route. When your ultimate goal is to provide for your family while striving for financial independence, greed doesn’t enter into the equation.