So you’re ready to start your FIRE journey. You start looking at articles and videos about finances and investing, but you run into so much jargon! Finance articles all use the same jargon: Equities vs fixed income, securities, asset allocation, risk, but these words don’t mean much to the common investor. Honestly, you don’t even need to understand most of it. Here’s a list of the important common financial terms and their definitions. (Picture source: Attyca)
Common terms you need to know
Equities vs Fixed Income: Equities are another name for stocks because by owning a share of stock, you own a share of the equity in a company. Fixed income is just a fancy term for bonds because when you own a bond, the bond issuer pays you a fixed amount based on the contract of the bond when you bought it. The income is fixed even if the price/value of the bond changes.
Securities or Assets: An asset is anything that increases in value. This means that a house is an asset. Securities are publicly traded assets like stocks and bonds. There are other securities like gold or real estate investment trusts, but for the sake of simplicity the two most important securities are stocks and bonds.
Mutual Funds: a bundle of many different securities. There are mutual funds that hold healthcare company stocks, or utilities, or pretty much anything you can think of. There’s even a video game mutual fund. Mutual funds are safer than buying individual stocks because it’s harder for all of the stocks in a fund to go down at the same time. Unlike stock you don’t have to buy a whole share of a mutual fund. For example you purchase $100 worth of a mutual fund even if that is 1.23 shares.
ETF: Exchange Traded Fund, very similar to a mutual fund but you have to buy it in whole units. The price per share is usually less than a mutual fund. Sometimes they have lower expense ratios than their equivalent mutual funds.
Index: A marker of a segment of the stock market. This is not a fund in an of itself, its more like a spreadsheet of assets. An example of an index is the S&P 500 Index which tracks the 500 largest US companies, weighted by market cap (how much the entire company is worth). This index is widely regarded as the best gauge of the overall stock market. The Dow Jones Industrial Index (DJIA) tracks 30 large multinational companies that have been in existence for many years, weighted by stock price. The Nasdaq Composite Index tracks 2500 companies and is 50% technology stocks.
There are also indexes for securities other than stocks. For example there is an aggregate bond index which tracks government and company bonds. There are housing and real estate indexes, and even gold and silver indexes.
Index Fund: A mutual fund or ETF that tries to replicate an Index. For example an S&P 500 Index Fund will try to replicate the S&P 500 Index by having the same amounts of the same companies. Index funds generally have very low expense ratios because they don’t have a manager who is trying to pick winning stocks. They just follow the index.
(Expense ratio) MER: Expense Ratio, also called Management Expense Ratio, is the percent of your invested money that is charged in management fees. For example if you have $10,000 in a mutual fund and the MER is 1%, you will owe $100/year. Typically the expense ratio is higher for actively managed funds (1%-2%) and lower for index funds (<0.5%). Index funds can have a very low MER because there is no need for a manager to pick stocks – it just follows the index.
The idea of an actively managed fund is that a smart fund manager (and his extensive team of financial analysts) can pick the best stocks to put into his fund. The expense ratio is the fee that he charges to help you beat the general stock market. The hope is that an actively managed fund will out-perform the general stock market by more than the 1%-2% fee it charges, but when you look at the last 15 years, 90% of actively managed funds not only failed to beat the market by 1%-2%, they actually underperformed the general market. So the expense ratio is essentially a fee you pay to have some financial manager perform worse than you would by yourself.
Another reason is that actively managed funds are buying and selling stocks to try to get ahead, but every time you sell a stock you have to pay taxes on it. Therefore actively managed funds have a higher tax burden as well.
Asset Allocation: This is the ratio of assets that you choose to hold. For example if you have 60% of your money in stocks and 40% in bonds you have a 60/40 asset allocation. Your asset allocation determines your risk. Since stocks are riskier than bonds a 60/40 asset allocation will be less risky than a 90/10 spit.
Your asset allocation should change as you grow older and closer to retirement. When you are younger it doesn’t matter how bad the stock market crashes, because you are still putting money into your retirement savings. The average market correction lasts 6 months, so if you are more than a couple years away from retirement, don’t worry about it.
If you are less than 5 years away from retirement you should be more conservative. A 60/40 stock/bond asset allocation is a good way to be able to weather market corrections while still allowing your nest egg to grow. The way to do this is to sell some of your stocks and use the money to purchase bonds.
Traditional IRA: An IRA, which stands for Individual Retirement Account, is a savings account that allows individuals to contribute a limited amount per year. As of 2021 people under 50 years old may contribute up to $6,000 per year and deduct those contributions from their taxable income. When in an IRA money can be invested in the stock market without having to pay dividend or capital gains tax. After the individual has reached age 59½ they may withdraw their money from their IRA. The withdrawals are then taxed at their current tax rate. A traditional IRA is considered a tax-deferred account because you don’t pay taxes on the money you contribute to your IRA, but you do pay taxes on what you withdraw. Also if you withdraw from a traditional IRA before you reach age 59½ you will have to pay a 10% penalty on top of the taxes.
Roth IRA: A Roth IRA is like a traditional IRA only you don’t get to deduct your contributions from you taxable income. The upside is that you don’t have to pay taxes on your withdrawals. This means that none the money that you get in interest or dividends is taxed. Another upside is that since you already paid taxes on your contributions, you can withdraw that money before you turn 59½ (though you still have to wait to withdraw the interest accrued or you’ll get slapped with a 10% penalty). Because of this perk, a Roth IRA can be an extremely helpful tool in pursuing early retirement. So which is better, a traditional IRA or a Roth IRA?
401(k): A 401(k) is very similar to an IRA (there are both traditional and Roth variants). The difference is that a 401(k) is employer sponsored. This means that you only get the investment opportunities that the employer has agreed to. They are usually target date funds and index funds so that’s fine. The advantage is that your employer may match some contributions you make to your 401(k) so that’s free money! Also the contribution limits on a 401(k) are $19,500 in 2021. That’s more than three times as much as you can contribute to an IRA.
Taxable account: This is a regular investment account also called a brokerage account. The money put into this account can be used to invest in the stock market. Unlike an IRA or 401(k) you can put as much money into this account as you and want and can withdraw money whenever you want. The downside is that you have to pay taxes on interest, dividends, and capital gains.
Dividend: A distribution of some of a company’s earnings to shareholders. When a company makes a profit for the year it has options for how it can use the money. It can hold onto the cash for a future time, it can use the profits to buy more equipment or capacity, or it can give money to its shareholders. All of these options increase the value of the company which then makes the stock valuable. Holding cash increases the company’s bottom line, investing in itself to increase capacity will make the company more profitable in the future, and passing profits along to shareholders makes the company’s stock more valuable to investors. Bigger companies that don’t have the ability to expand usually pay out higher dividends because they can’t find better things to do with the money.
Capital Gains: Capital gains are the profits you make on selling an asset. For example if you purchase you house for $200,000 and later sell it for $300,000 you capital gain is $100,000. In the case of the stock market, if you purchase 10 shares of a stock or index fund at $20/share and you sell them 20 years later for $100/share, your capital gains are $80 times the 10 shares or $800. If these stocks were held in a taxable brokerage account you would have to pay capital gains taxes on that $800 profit. If they were in an IRA or 401(k) you wouldn’t have to pay capital gains taxes on that $800 profit.
Short Term vs. Long Term Capital Gains: The IRS puts capital gains into two different categories, short term and long term capital gains. Short term capital gains are profits made from assets held for less than a year, and long term capital gains are profits made from assets held for more than a year. The reason for this distinction is because they are taxed at different rates.
Short term capital gains are taxed at you normal income tax level whereas long term capital gains are taxed at a much more convenient rate. This is to encourage people to buy assets (like index funds) and hold them until they retire. As you can see below a married couple filing jointly can sell stock for a profit of $80,800 every year without having to pay the IRS a dime. But if they didn’t hold the stock for a full year they would have to pay about $9,000 in taxes on that $80,000.
| Tax rate | Taxable income bracket | Tax owed |
| 10% | $0 to $19,900 | 10% of taxable income |
| 12% | $19,901 to $81,050 | $1,990 plus 12% of the amount over $19,900 |
| 22% | $81,051 to $172,750 | $9,328 plus 22% of the amount over $81,050 |
| 24% | $172,751 to $329,850 | $29,502 plus 24% of the amount over $172,750 |
| 32% | $329,851 to $418,850 | $67,206 plus 32% of the amount over $329,850 |
| 35% | $418,851 to $628,300 | $95,686 plus 35% of the amount over $418,850 |
| 37% | $628,301 or more | $168,993.50 plus 37% of the amount over $628,300 |
| Long-term capital gains tax rate | Investment income bracket |
| 0% | $0 to $80,800 |
| 15% | $80,001 to $501,600 |
| 20% | $501,601 or more |
Inflation: Inflation is the gradual rise in costs of goods and services. As a result of inflation, the purchasing power of the dollar decreases. The Federal Reserve attempts to keep inflation at around 3% per year. As a general rule this means that prices will double roughly every 20 years. This is important to remember for retirement because if you plan to retire in 20 years assume that things will cost twice as much as they do now.
Required Minimum Distribution (RMD): If you have a traditional or Roth 401(k) or traditional IRA, the IRS requires you to take withdrawals of at least a certain minimum by April 1 of the year following the year you reach age 72. This is to make sure they get their cut of your taxes. If you don’t withdraw at least the required minimum distribution, you get slapped with a penalty of 50% of that value. However if you have a Roth IRA there are no required minimum distributions because you have already paid taxes on that money.
This isn’t an exhaustive list of financial terms by any stretch of the imagination, but I hope it’ll be enough to at least get you started. What do you think? Did I miss any important jargon or fail to explain something clearly enough? Let us know in the comments below, and I’ll update this page!
