You’ve heard a lot about it. You may have flipped past MSNBC and saw the green and red arrows and the acronyms and wondered “What does it mean?” and “Why do people care so much?” Before we go into what those arrows mean and why the talking heads on those networks continue to blab on let’s strip away all the opinion and discuss the facts concerning stocks. (You’ll notice I am not going to discuss much of the mechanics of how stocks are traded that is the subject of the next lesson).
You have probably seen commercials about “improving your credit score” or companies that will “give you your credit score” now you may be thinking “What the hell is a credit score?” Put simply a credit score is a three digit number that indicates how reliable you are as a borrower. Why does that matter? When you apply for a loan at a bank the bank has to evaluate whether to loan you the money and what interest rate to charge you. If only there were a way for a bank to see how you have paid other loans and whether you default (don’t pay) on a lot of loans. Surprise! There is a way and it is called credit-scoring systems. So before we delve deeper remember that the better your credit history and thus your credit score, the easier it is to obtain a loan and the lower the interest rate you will be charged. Also remember that debit card payments and cash payments are not relevant here. Only credit financing (credit cards, loans, etc.) affects your credit score and credit report.
So we have discussed a bit about returns and rates, but there is some terminology that needs to be addressed and will make you a bit better off for knowing it. At the end of the day interest rates are pretty powerful things that shape the entire financial system, so let’s learn a little more about them. (Warning: simple math ahead so non-math types bear with me).
“Don’t put all your eggs in one basket”
-An interpretation of a line in Don Quixote
So we know that given a return we don’t want to take on any more risk unless we have the possibility of more gain. Great! How do we minimize the risk we already have? As the cliché phrase above hints at one way commonly used to manage risk is the practice of diversification. Let’s start by defining it.
- Diversification is an essential aspect of any investment strategy
- Diversification decreases risk of a portfolio by decreasing volatility of the entire portfolio
- Diversification is useful up to a point, but exhibits diminishing marginal returns
It has been in my learning experience that there is no one definition of the word risk. There are many variations on the concept and many ways to view it.
Risk in my opinion could best be described as “uncertainty of results due to the inherent unpredictable nature of the future”. To put risk differently if you had psychic powers and could accurately see what the future held you would have no risk in your life as there would be no uncertainty to outcomes.
- Risk is the chance that your expectations concerning a return are not what actually occurs
- There is a fundamental relationship between risk and return of an investment
Let’s begin with a pretty basic idea and define what an investment is. You have probably heard “John bought Apple stock years ago that turned out to be a great investment” or “by earning a college degree I am investing in myself.”
An investment in its simplest terms is a purchasing of an asset in with relative certainty that the asset you purchase will generate income and/or increase in value. Another way of looking at an investment is that you are sacrificing immediate consumption in hopes of a greater payoff at some point in the future. Let’s go through some examples to paint a clearer picture.
- An investment is an asset that will either increase in value and/or generate income.
- Returns are how we measure how “good” or “bad” an investment is.