Finance can be a frustrating topic, largely due to all the terminology. In my articles on Seeds I try to be consistent in terms I use, but what I call stocks and bonds other people may call equities and fixed income. As I refer to various sources in the Personal Finance section of Seeds we are forced to encounter different terms, and so I created this article to clear-up any confusion this causes.
The purpose of this article is to provide a brief outline of the different terms used in finance and what they mean. Only terms relevant to Seeds articles are included.
- Stocks—also referred to as equities, because owning a stock means you have partial ownership in the corporation, and ownership is often called "equity". Because stockholders literally own the corporation, when profits are earned and all loan payments are made, whatever is left is for the stockholders. Stockholders make money either by selling stock for more than they purchased it (this is referred to as capital gains) or through dividend payments, which are direct cash payments to the stockholders. Dividends are only paid after all lenders are paid, so stockholders can lose all their money if the corporation fails. If the corporation thrives, however, there is no limit to what stockholders can make, whereas bondholders will only receive what was promised to them. One drawback to owning stock is that your profits are taxed twice: once at the corporate level, and once at the personal level.
- Bonds—sometimes also enveloped within a category called fixed income. For instance, in my retirement plan with TIAA-CREF there is a fixed income category that includes three different types of bonds. When you buy a bond you are lending an organization money, and the borrower may be a business or a government. The bond is a legal contract to repay you a fixed number of dollars at a precise point in the future. Most of the time the organization survives and you are repaid the exact number of dollars you are promised. In some cases, like those who recently purchased bonds from the Greek government, the borrower cannot fulfill its promise and you only receive a fraction of what was owed. The major risk with bonds is that there will be unexpected inflation, and the dollars you are promised are worth less than you thought they would be. Bonds are usually for one year or longer.
- Cash Accounts—are short-term, very safe accounts, and include money market accounts, certificates of deposits (CD's), and savings accounts. Cash accounts are like bonds, except the money is not lent for long (less than a year). Like bonds, you are promised a certain number of dollars in the future, and if the organization goes bankrupt you are the first group to salvage whatever value is left. Also, because the money is lent for short periods of time, if unexpected inflation occurs it will not depress your wealth for long, allowing you to quickly renegotiate a better interest rate.
Another frequently used term is annuity, which is an instrument that pays its owner a steady stream of money for a number of years. That stream of money may or may not be adjusted for inflation. Some people save a big pile of money for retirement and must live off it from the day they retire till they die. How should these savings be managed? One option is to keep the savings at the bank in a cash account, earning a low interest, and withdrawing a portion of it each year for living expenses. If managed poorly, or if the person lives longer than they expected, they may run out of money before they die.
To prevent this from happening some people use their retirement savings to purchase an annuity. The owner of an annuity is guaranteed a yearly payment throughout the lives of both spouses. For example, John may use the $1.5 million he saved for retirement to purchase an annuity, which gives him and his wife a yearly income of $60,000 every year they live. The value of this annuity payment will generally increase with inflation. The appeal of an annuity is that the annual income it provides will never run out, no matter how long the owner of the annuity lives.
(1) The Risks That Bonds Carry
