Building Wealth Like many professions, finance has a language of its own.
If you're not part of the club (and even if you are), it's easy to get the lingo wrong. And that can lead to very expensive mistakes.
You've probably even seen a lot of "financial jargon" here in Health & Wealth Bulletin. You might think you understand some of the most often-used phrases, but the truth is, you likely don't.
So to help you avoid making mistakes, today I (Kim Iskyan) am sharing some of the most frequently misused words in finance and what they really mean...
1. Volatility
What People Think It Means: Volatility is often misused as a synonym for "uncertainty." The two words are frequently used interchangeably. Volatility is also often framed as a bad thing. Look out for the CNBC talking head muttering – with a stricken look on his face – about how there's "too much volatility" in markets right now.
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.
If a stock has low volatility, it means it doesn't make extreme moves beyond its average price. If it has high volatility, it means the price swings are bigger.
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 world, shares of real estate development company NVR, which trade at nearly $4,400 per share, are "expensive." And shares of Texas-based oil producer Kosmos Energy, which trade under $6 per share, are "cheap."
What It Really Means: The price of a stock has nothing to do with whether it's cheap or expensive. In the investment world, cheap and expensive refer to a stock's valuation – which is measured by, for example, the price-to-earnings ratio (P/E), which compares a company's share price with its net income.
In this case, NVR's current P/E is 10. And Kosmos is barely profitable, sporting a P/E of 444. NVR shares, each of which costs more than the average mortgage payment, are cheap – while shares of Kosmos Energy, which change hands for the price of a cup of coffee, are nosebleed expensive.
3. Median vs. average
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 seven people in a classroom – six kids and one teacher. Here is a list of their ages: five, six, six, seven, seven, eight, and 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 seven 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 – seven years. So, the median age is seven.
This distinction is significant in interpreting 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. 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 $10,000 to invest. Your bank offers you a product that offers a 4% nominal rate per year, with monthly compounding interest. How much money will you have at the end of the year?
Four percent of $10,000 is $400, suggesting a final sum at the end of the year of $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 $10,000 would be worth $10,407 after one year. That means the effective interest rate, or what you effectively earned, is 4.07%, 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.
Learning the language of finance is an important step toward understanding what's happening in the world of money. And it's also a helpful way to arm yourself against "car-mechanic syndrome"...
Best regards,
Kim Iskyan
July 28, 2022