Investment Terms You Should Know

Here are some terms you may encounter as an investor.

Simple Interest 

This is interest calculated on the principal you invested.

For example, if you invest $1,000 at an annual interest rate of 5 percent, you would earn $50 in interest after the first year. You would earn another $50 in the second year and ever subsequent year.

Compound Interest

This is interest calculated on both the principal you invested and the interest you accumulated over a previous period. 

For example, if you invest $1,000 at an annual interest rate of 5 percent, compounded annually, you would have $1,050 after one year. In the second year, you'd earn interest on $1,050, not just the initial $1,000. As a result, you earn more money with compound interest than simple interest. 

Liquidity

Liquidity refers to how quickly and easily you can convert your investment into cash without significantly affecting its value. For example, you can usually sell shares in large companies quickly while real estate is less liquid.

Risk and Reward

Investing is a balancing act between risk and reward. Risk refers to the possibility of experiencing a loss or an unfavourable outcome. Reward refers to the potential financial gain or return that an investment can generate such as dividends or interest. Generally, the potential for higher rewards comes with higher risk. 

Risk Tolerance

How much risk you are willing and able to take on. Types of risks include:

• Market Risk - The possibility of investments declining in value due to economic developments
• Credit Risk -The possibility that the entity issuing a bond will default on payments
• Inflation Risk - The possibility that inflation will erode purchasing power.

Time Horizon

Your time horizon is the number of years you expect to be investing to achieve your financial goal. 

A short-term investment is typically one that matures in under five years while a long-term investment typically matures in 10 years or more.  A shorter time horizon increases liquidity, enables you to get returns more quickly, and reduces exposure to market volatility. A longer time horizon allows you to take more risks because you have more time to recover from potential losses.

Diversification

Diversification refers to spreading your investments across various types of assets and sectors to reduce risk. A diversified portfolio is less likely to experience significant losses because if one investment performs poorly, another could offset it. 

Asset Allocation

Asset allocation is the strategy cash of dividing your investments among different asset categories—such as stocks, bonds, and real estate. The right mix depends on your risk tolerance, investment goals, and time horizon.

Average Cost Investing

Average cost investing or dollar-cost averaging is a strategy where you invest a fixed amount of money regularly, regardless of the asset's price.