Decoding Finance Speak - What Does Your Financial Advisor Mean?
By Russell W. Hall, CFP®
Almost every industry has its own jargon, and financial services is no exception. At Eclectic Associates, we do our best to explain investing and financial planning in terms that are easier to understand…but even we fail at that from time-to-time!
Below are five examples from our own quarterly letters to clients, with an explanation of each term. Some of these ideas are more complicated and could easily take up an entire article on their own, but we’ve kept definitions shorter here on purpose.
Price-to-Earnings (P/E) Ratio: One measure of how expensive or cheap stocks appear to be, calculated by taking a stock’s price divided by the company’s earnings per share. As with most tools for measuring stocks, the devil is in the details in terms of how the calculation is done. You could use the most recent earnings (“current P/E”) or what analysts expect the company to earn (“future P/E”), for instance.
Price-to-earnings ratio is not a perfect measurement – there are companies that don’t have any earnings yet – but it’s a quick way to easily compare how the market values a particular stock and be able to compare that against other stocks or index.
Market Volatility: Simply put, volatility means how much the stock markets are moving either up or down. Low volatility would mean smaller swings in stock prices, while high volatility will mean more dramatic swings.
When we or other advisors reference market volatility it’s usually in reference to volatility being high, with prices bouncing around a lot. Think of a commentator on the radio - “The S&P 500 index was down 2.3 percent in a volatile day of trading.”
Capital Gain Distributions: When you buy or sell an investment in a taxable (non-retirement) account, you could have a capital gain or a loss depending on what you paid for that asset and what you sold it for. Mutual funds and other pooled investment vehicles incur these same types of gains and losses as they internally buy and sell investments. Then, towards the end of each year they pass any net gains along to their shareholders in the form of capital gains distributions. Those distributions are taxable income when you receive them.
In recent years, large gains in the markets have led to higher capital gain distributions and perhaps some unpleasant surprises on your tax return. We actively look for ways to manage and plan for capital gain distributions.
Correction: A fancy way of saying that stock prices have fallen at least 10% but not more than 20% in value. Over the long-term, stocks tend to “revert to the mean” – that is, they frequently move above or below their fair value, but eventually come back to their long-term average return. Thinking about it that way, a correction could mean that stocks had gotten too expensive and were correcting back to be valued more appropriately.
Credit Spreads: This term is used in reference to fixed income (bonds) as a way to measure value by comparing their yield to US Treasury bonds.
Probably the easiest way to discuss credit spreads is with an example. If a US Treasury bond maturing in ten years is priced to yield 2.3% until it matures, and a bond from a lower-rated US company is paying 4.1% over the same period, you would say that the spread is 1.8%. In other words, bond investors are willing to take on more risk and only receive 1.8% more than they would get by buying the “risk-free” asset of US government debt.
Financial advisors often talk of credit spreads “widening”. That means that bond prices have fallen, so the yield on those bonds has increased and the spread is bigger. In our example, perhaps the lower-rated company is now yielding 5.9% and the spread would now be 3.6%. “Tightening” is the opposite, where bond prices increase and the yield spread is now less.
If you need help decoding any financial language you’re trying to understand, please contact us! Schedule a 15-minute discovery call with a fee-only financial advisor.