Like most professions, finance has a language of its own. It’s easy to get the lingo wrong. And that can lead to very expensive mistakes.
To help you avoid that, what follows are some of the most frequently misused words in finance… and what they really mean.
What People Think It Means: Volatility is commonly mistaken for “uncertainty.” Many people use the two words interchangeably. Volatility is also often framed as a bad thing. Look out for the talking heads muttering about how there’s “too much volatility” in markets right now.
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What It Really Means: Volatility is just a way to measure the change in the price of an investment over a particular period of time. Whether stocks are going up or down, the amount they move either way is the stock’s volatility.
In the graphs below, both Company A and B have an average share price of US$30. But company A has bigger price swings, so it is the more volatile of the two.
If a stock has low volatility, it means it doesn’t make extreme moves beyond its average price. If it is has a lot of volatility, it means the price swings are bigger. But these movements are simply short term. For assets held over a longer period of time, these day-to-day movements have little impact.
One final thing to bear in mind is there’s a difference between realised volatility and implied volatility.
Realised volatility simply measures the past historical price volatility over a specified period (say, the trailing 30-day volatility). Implied volatility on the other hand is the level of volatility implied in the future and is derived from option prices. Volatility is a critical component of option pricing.
2. Cheap/expensive stock
What People Think It Means: Some investors look at the price of a stock and make a declaration about whether it’s “cheap” or “expensive”. In this alternate world, shares of beer giant Molson Coors Brewing (traded on the New York Stock Exchange; ticker: TAP), which trade at around US$84 per share, are “expensive”. And shares of global banking group Standard Chartered PLC (Hong Kong Exchange; ticker: 2888), which trade at around US$12.0 per share, are “cheap”.
What It Really Means: The price of a stock has nothing to do with whether it’s cheap or expensive. When financial professionals talk about cheap and expensive stocks, they are referring to a stock’s valuation. Valuation is often measured using ratios like the price-to-earnings ratio (P/E). This compares a company’s share price to how much money the company makes.
In this case, Molson has a P/E of about 8 times. And Standard Chartered is barely profitable, and sports a P/E of 395. Molson shares are cheap – and Standard Chartered shares are nosebleed expensive, based on current earnings. Price and value are by no means related.
3. Median vs. average (or mean)
What People Think It Means: There’s an important difference between median and average (which is usually the “mean”). Both median and mean refer to a midpoint in a series of numbers. But the way they’re calculated is very different.
What It Really Means: Let’s say there are 7 people in a classroom – 6 kids and one teacher. Here is a list of their ages:
5, 6, 6, 7, 7, 8, 36
The average (mean) age of everyone in the classroom is calculated by adding all the ages, and dividing by the number of people. So the sum of the ages is 75… and divided by 7 results in an average age of 10.7.
Of course, the teacher’s age skews the results. In this case, the mean isn’t representative of the age of everyone in the room. Six of the seven people in the room are younger than the average age.
A more accurate indicator is the median age. The median is calculated by arranging the values from lowest to highest and picking the one in the middle – 7 years. So, the median age is 7.
Knowing the difference between the two helps you understand economic and other data. For example, in many countries, the average (mean) household income is a lot higher than the median, because the average is skewed by the very wealthiest households. The median is much more representative, because when incomes are listed from lowest to highest it’s the number in the middle.
4. Capital protection
What People Think It Means: Some financial products are advertised as offering “capital protection.” This term makes it sound like investors are fully protected against losses. But that’s only part of the story.
What It Really Means: A capital protection product “protects” only the initial invested sum. So, if you deposit US$50,000 and the investment grows to US$75,000, only the original US$50,000 is protected.
The capital protection element kicks in if the investment falls below US$50,000. The investor could ask for the return of his original US$50,000 (possibly minus fees). There’s no such thing as a risk-free investment, but capital protection can at least limit losses, similar to a stop-loss for a stock investment.
5. Nominal vs. effective interest rates
What People Think It Means: Interest rates on loans are sometimes quoted as nominal or effective. Many bank products have these rates stated on their marketing material. And there’s an important difference between the two terms.
What It Really Means: Let’s say you have US$10,000 to invest. Your bank offers you a product that offers a four percent nominal rate per year, with monthly compounding. How much money will you have at the end of the year?
Four percent of US$10,000 is US$400, suggesting a final sum at the end of the year of US$10,400. But that’s based on the nominal, or stated, interest rate. Note, though, that the interest rate compounds monthly. This means that interest is paid every month – with the interest earned each month then earning interest, or compounding.
Because any interest you’ve earned each month will start earning interest, the actual final interest rate, or the effective rate, is slightly higher than the nominal rate. In this example, with monthly compounding, your US$10,000 would be worth US$10,407 after one year. That means the effective interest rate, or what you effectively earned, is 4.07 percent, or 0.07 percentage points more than the nominal rate.
That seemingly small difference can matter a lot more over long periods of time – and when interest rates are higher. For example, credit cards may charge a nominal rate that compounds monthly, resulting in a far higher effective rate.
Having a clear understanding of these key financial terms will help you manage you finances better – and avoid any nasty, expensive surprises.