No question about it: financial planning can be confusing.
One factor that can be daunting to
many people is the technical jargon used by professionals and financial media
outlets. Below is a simple description of terms that are commonly used in
financial reports and presentations:
Inflation-
This
is the erosion of purchasing power over time. For example, $100 at the beginning of the
year buys less than $100 at the end of the year. If the annual inflation rate is 5 percent,
the $100 you spend on groceries in January buys only $95 worth of food in
December. The inflation rate also
affects savings. If a savings account earns 1 percent interest during a year
with a 5 percent inflation rate, you lose 4 percent of the purchasing power of
the money in savings.
Interest
Rate
– The percentage charged by banks or credit card companies for loaning money or
the percentage paid by banks for borrowing your money held in savings accounts,
checking accounts, or certificates of deposit.
Actions by the Federal Reserve’s Federal Open Market Committee (FOMC) influence the
interest rates charged to consumers. In 2022, the FOMC has been gradually increasing
interest rates in incremental steps in an attempt to lower inflation.
Consumer
Price Index (CPI)
– The Consumer Price Index (CPI) is a measure of inflation used by the U.S.
Bureau of Labor Statistics. It is updated monthly. Changes in the
price of goods and services (e.g., energy, food, cars) are tracked and
recorded. Because people may not buy the
same “basket” of goods measured by the CPI, and because inflation affects
people differently, the CPI may overstate or understate the true rate of
inflation for individuals and families.
Median Income- The median is
the exact halfway point (midpoint) in a distribution of numbers from the lowest
to the highest. In other words, half of the numbers are below the median and
half are above it. The median household income in the United
States was $67,521 in 2020, down from $69,560 in 2019. Median income is
typically used to report household financial status because average income
figures are skewed by a small percentage of extremely high earners.
Dow
Jones Industrial Average (DJIA) – The Dow Jones Industrial Average is a price-weighted average of prices of
stocks from 30 industry-leading U.S. companies. It is widely quoted each day at
the close of market trading as a barometer of stock market activity. Because
the DJIA uses such a small number of stocks, it is often criticized for not
representing the entire stock market, which is why other indexes, such as the
Standard and Poor’s 500 and Russell 3000, also are used.
Dollar-Cost
Averaging-
This term is used to describe the process of investing the same amount of money
on a regular basis regardless of market performance. For example, $100 in a
mutual fund or 5% of pay every payday in an employer retirement savings plan. Dollar-cost averaging works best if
investment deposits are “automated,” such as authorizing 401(k) plan payroll
deductions or automatically debiting a bank account monthly for mutual fund
share purchases.
Buy
and Hold- A long-term passive investing strategy where investors
purchase stock, stock mutual fund, or exchange-traded fund (ETF) shares, particularly
from companies with a history of steady earnings or growth, and keep them for a
number of years regardless of market performance. Buy and hold investing can
often outperform actively-managed investing because trading expenses are
reduced and capital gains taxes are deferred.
Time Diversification- The reduction in
risk that often accompanies the lengthening of an investor’s time horizon. What matters most in investing is not market timing,
but time in the market. Historical evidence indicates that long-term investing can
reduce the risk of losing money and enhance potential returns. Time decreases
the amount of volatility (i.e., ups and downs in prices) of investments. As the
time frame increases to 15 to 20 years, extreme volatility flattens out.
Rule of 72- To estimate how long it will take to double a sum of money (any amount), at
a given rate of return, divide 72 by the interest rate. For example, money will double in seven years
at 10%, eight years at 9%, nine years at 8%, ten years at 7%, and 12 years at
6%. The Rule of 72 can also be used in reverse to calculate the interest rate
required to double money. Simply divide
72 by the specified time period. For
example, 72 divided by 8 years = 9% interest.
For
additional definitions of financial and investing terms, review this glossary from
Rutgers Cooperative Extension.
This post provides
general personal finance or consumer decision-making information and does not
address all the variables that apply to an individual’s unique situation. It does
not endorse specific products or services and should not be construed as legal
or financial advice. If professional assistance is required, the services of a
competent professional should be sought.
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