7 Financial Planning Terms You Need to Know
Navigating the complex world of financial planning can be challenging without assistance from a Certified Financial Planner (CFP®) or other qualified professional. Even with professional assistance, it's important to be engaged and have a strong grasp on how and where your money is invested. To properly do this, investors need to be aware of several key terms, including the seven listed below:
When the term "net worth” is used, it's often associated with celebrities, athletes, business executives, and other wealthy individuals. However, everyone has a net worth, and it's an important figure to gauge your financial situation. Moreover, it can also be useful in establishing future financial goals.
Net worth refers to the difference between a person’s assets and their liabilities or, in a simpler sense, what they own and what they owe. Assets can be anything from real property such as a home or vehicle to investment and checking accounts. Liabilities, meanwhile, include a mortgage balance, student loans, credit card debt, and other financial obligations.
According to the most recent Survey of Consumer Finances issued by the Federal Reserve Board, the median net worth among American families is $97,300. Generally speaking, this figure should increase with age. This was true in the survey as the median net worth of families with a head of the household between the age of 35 and 44 was $59,800. It increased in each subsequent age group up to $264,800 for families in which the head of the household was at least 75 years old.
Compound interest can be good or bad depending on where it is applied. For instance, compound interest on one's credit card can make debt accumulate quicker than just simple interest. Conversely, compound interest on investments can make your balance grow at a faster rate.
Dave Nugent, head of investments at Wealthsimple, explained it best in an article in Reader’s Digest: "Compound interest is the principle by which the interest you earn also earns interest, and the interest on that interest earns interest, and so on forever. The larger your balance gets, the bigger those interest numbers become."
In order to calculate the compound interest rate, multiply the initial principal investment (P) by one plus the annual interest rate (i) multiplied by the power of the number of compound periods (n) subtracted by one. The formula looks like this:
P [(1 + i)n – 1]
For instance, an initial investment of $100,000 with a 5 percent interest rate that compounds annually would return an additional $62,889.46 over a 10-year period. Without compound interest, the same investment would return $50,000 over the same period.
Diversification refers to how you spread your investments and is an integral aspect of investment management. Stocks and other investment assets are prone to volatility and, for that reason, it's best to invest in a range of different types of investments. A CFP® can help individuals select a diverse mix of low- and high-risk investment opportunities to provide balance to their portfolio.
Asset class refers to a category of investments with similar characteristics. The three main asset classes are fixed incomes (bonds), equities (stocks), and cash and equivalents. This third category encompasses money market instruments such as US government Treasury bills, corporate commercial paper, and bank certificates of deposit. However, the majority of investment professionals also include commodities, futures, real estate, and cryptocurrencies as separate asset classes. CFP® and other wealth managers utilize various asset classes to help their clients diversify their portfolios.
Individual retirement accounts (IRA) are savings vehicles specifically designated to hold investments for the purpose of retirement. The holders of these accounts can put away a certain amount of money per year and receive tax-deferred earnings until they are 59 and a half years old, at which point they can withdraw from the account. Withdrawals can be made at an earlier date, but accrue a 10 percent penalty. These accounts can be set up at a brokerage, bank, or mutual fund.
Diversifying your portfolio is one way to mitigate risk, but those looking for added security against short- or long-term losses may consider hedging. This generally involves short selling or using derivatives like options, futures, and swaps to protect against adverse price movements of particular assets.
For instance, you can purchase 100 shares of a stock at $10 per share with a $5 American put option and $8 strike price that expires in one year. Should the stock drop below $8 by the end of the year, the investor is likely to exercise the option. This will result in a loss of money from the original investment, but protects against even greater losses.
Commodities are physical assets that bought, sold, or traded on exchanges such as the Chicago Board of Trade and New York Mercantile Exchange. They are split into two different groups: hard and soft. The former refers to natural resources like gold and oil, while soft commodities encompass livestock or agricultural products. These can be invested in via futures contracts or by purchasing index funds, mutual funds, or exchange-traded funds that emphasize commodities-related businesses.