Finance Terms Your Advisor Uses, but May Not Explain

All professions have their own language- terms unique to the industry that describe specific ideas to those who think about them each day. Individual companies even have their own language. Employees reduce phrases, names, and titles to acronyms. The first day on the job can make a new employee feel like a stranger in a foreign land.

The financial services industry is not immune to this phenomenon. Although many advisors use such language simply out of habit, it often seems like people in the business and the talking heads on TV use arcane language for the sole purpose of “sounding smart” to those who don’t understand the terms. The irony for advisors is that clients who hire them do so often because they recognize that finance lies outside their sphere of expertise and using jargon or failing to explain key terms is a disservice to the client.

A study by the Knowledge Academy, recently featured in Financial Advisor Magazine, highlights several finance terms with which Americans were least comfortable. We thought it would be helpful to define some of these terms.


Liquidity refers to the speed with which an asset can be bought or sold at the market price. Cash is considered the most liquid asset- nearly every purchase or sale can be transacted in cash. Illiquid assets include things like fine art or real estate. Consider how long it takes to sell a home. Even if you were able to get a cash offer for your house today, it would still likely take a few weeks to actually receive the cash. The buyer will want a home inspection, title search, title binder, etcetera. Likewise, you might be able to sell a piece of fine art in a few hours, but how likely is it you received the best price?

Why is liquidity important?  When we look at a client’s assets from a financial planning perspective, we want to make sure they have enough liquid assets in an emergency fund to be prepared for any unexpected expenses. We also make sure clients have enough liquidity to meet their short-term needs on routine bills. You wouldn’t want to have to sell a collectible car just to afford next month’s mortgage.

What Does Liquidity Mean

Asset Allocation

Asset allocation refers to the weighting of each asset or asset class in your portfolio. To take a simple example, let’s say you had $1000 invested in bonds and $1000 in your savings account. Your asset allocation would be 50% bonds and 50% cash. There are many different ways of looking at asset allocation from very broad to very granular. The two most common ways we look at allocation are the broad equity and fixed income allocation for the account (60% Stocks and 40% Bonds for example) and the allocation we give to each stock (3% of the account in Apple for example).

What is Asset Allocation

Capital Gain/Loss

While the term “capital gains” often refers to a gain on the sale of a financial asset, a capital gain can occur when you sell any asset for more than you paid for it. Likewise, a capital loss occurs when you sell an asset for less than you paid. Importantly, capital gains are taxed differently than ordinary income or wage income. The capital gains tax rate depends on two factors- your income and the length of time you owned the security. When you hold the security for more than one year, capital gains or losses are considered “long-term.” For periods shorter than one year, capital gains and losses are considered short-term. There are three different long-term capital gains tax rates- 0%, 15%, and 20%. The higher your income, the higher the rate you pay on capital gains. It is worth noting that collectibles, including precious metals, are taxed at a flat 28%.

What happens if I have a capital gain and a capital loss in the same year? The mechanics are difficult to explain succinctly, but capital gains and losses can be “netted” against each other to offset one another.

How are short term capital gains taxed? Short term gains are taxed as ordinary income. The rates are the same as the rates on your wage income- resulting in taxation at a higher rate than long term capital gains.

Are dividends considered capital gains? Dividends are considered income. However, most dividends you receive on stock are considered “qualified dividends” which are taxed at the same rates as long-term capital gains. Depending on the holding period of your stock, you may also receive ordinary dividends. Ordinary dividends are taxed at the higher ordinary income rates.

What is a Capital Gain or Loss

Amortization and Accretion

The simplest definition of amortization is spreading out a cost over a period of time. As so often happens in finance, amortization can have several different meanings depending on the exact context. For example, when it comes to depreciating an asset, companies amortize or account for the cost of that asset over several years. Likewise, the mortgage payment on your home is amortized over the whole 30-year period allowing you to make the same payment each month.

The antonym to amortization is “accretion.” Accretion occurs when value is created after a transaction rather than lost. For example, a bond purchased at a discount accretes over time as the time to maturity decreases. While the concept is the same- spreading a larger amount over a period of time, accretion does not represent an expense but rather an increase in value.

What is Amortization

Mutual Fund

A mutual fund is an investment that consists of a pool of money from a large number of investors. There are a variety of different assets in which a mutual fund may invest. For example, there are very specific mutual funds that target just foreign technology companies and there are very general funds that invest in the entire world bond market. Mutual fund shares rise and fall in price along with the rise and fall of the value of the underlying assets.

Mutual fund shares cannot be “sold” on the open market. Rather, the shares are “redeemed” from the issuer who takes back the shares in exchange for cash. Furthermore, mutual fund redemptions only occur at the end of the trading day- you cannot trade mutual fund shares throughout the day. This is in contrast with ETFs which can be sold on the open market and which can be traded throughout the day. Mutual fund shares cannot be purchased on margin, nor can they be sold short.

The firm issuing mutual fund shares gets paid by charging an “expense ratio” to each investor. This functions similarly to an “assets under management” (AUM) fee charged by many investment advisors. This fee can range from extremely low (0.04% annually for example) to well over 1%. Equity mutual funds which invest in stocks are typically cheaper to own than bond mutual funds due to the complexities associated with managing a bond mutual fund. There are several other fees that mutual funds can charge in addition to the annual expense ratio, but these fees vary greatly from fund to fund.

What is a Mutual Fund

Exchange Traded Fund (ETF)

ETFs are similar to mutual funds in that they consist of a pool of money from a large number of investors and there are a wide variety of assets in which they can invest. The primary differences lie in the way ETFs are traded. ETFs issue shares which can be bought and sold on the open market. Whereas mutual fund shares are only purchased or redeemed from the issuer, ETFs can be purchased from or sold to other investors. ETFs can be sold very quickly and traded throughout the day. Furthermore, investors may purchase ETFs on margin and sell them short.

ETFs have gained popularity over the past few years for several reasons, the two most important being tax efficiency and low costs. Due to their legal and mechanical structure, ETFs create fewer taxable events compared to mutual funds. ETFs are also known for having led the way to lower costs which has forced mutual funds to lower their costs as well to compete.

What is an ETF

Index Fund

Index funds can operate as mutual funds or ETFs. They allow investors to purchase a “basket” of stocks that are contained in an index, such as the S&P 500. This allows an investor to make one purchase and immediately diversify their account.

What is an Index Fund

IRA (Individual Retirement Account)

An IRA is a catch-all term for a tax advantaged retirement account. There are many different “flavors” of IRAs that can be used to suit many needs such as Roth IRAs, Beneficiary IRAs and Rollover IRAs. The “tax advantaged” features vary based on the type of IRA, but the bottom line is that using an IRA for your retirement savings will help save you money on taxes.

What are the advantages to using IRAs? IRAs are very flexible from an investment perspective. Whereas employer retirement plans will typically only allow a limited number of investment options, IRAs can hold any stock, bond, mutual fund or ETF. IRAs are “protected assets” in the event of bankruptcy. The amount of the bankruptcy protection can vary based on your exact situation. Rollover IRAs (IRAs funded with money from an employer sponsored retirement plan) have an unlimited amount of bankruptcy protection. As long as the IRA is owned by the parents (not the student), IRAs can also be used to shield assets when applying for student aid. IRA assets as well as employer sponsored retirement plan assets are not counted on the Free Application for Student Aid (FAFSA). IRAs also allow for named beneficiaries meaning they pass outside of probate upon the death of the account owner.

In exchange for the tax advantages associated with IRAs, there is a complex set of rules by which IRA owners must abide when it comes to making withdrawals.

What is an IRA

Roth IRA

A Roth IRA is a specific type of IRA account that allows you to make contributions on an after-tax basis. Because contributions have already been taxed, as long as you follow the rules associated with Roth IRAs, withdrawals can be made tax free. This means that all the income and capital gains in your account can also be withdrawn tax free! Generally, tax free distributions can be made after age 59 ½.

Roth IRAs also have certain applications for education planning. For certain individuals, a Roth IRA can be a valuable vehicle for education savings while also providing great flexibility.

What is a Roth IRA

Part of our role as investment advisors and financial planners is educating clients on concepts they don’t understand and helping clients in areas outside their expertise. Whether it is a term you hear us using or a concept you’re seeing in the media, please do not hesitate to ask us for clarification. We love hearing from you and we are always here to help!