No question about it: financial planning can be confusing. Below is a simple description of terms that are commonly used in financial reports and presentations:
Inflation
This is the erosion of purchasing power over time. For example, $100 at the beginning of the year buys less than $100 at the end of the year. If the annual inflation rate is 5 percent, the $100 you spend on groceries in January buys only $95 worth of food in December. The inflation rate also affects savings. If a savings account earns 1 percent interest during a year with a 5 percent inflation rate, you lose 4 percent of the purchasing power of the money in savings.
Interest Rate
The percentage charged by banks or credit card companies for loaning money or the percentage paid by banks for borrowing your money held in savings accounts, checking accounts, or certificates of deposit. Actions by the Federal Reserve’s Federal Open Market Committee (FOMC) influence the interest rates charged to consumers. In 2022, the FOMC has been gradually increasing interest rates in incremental steps in an attempt to lower inflation.
Consumer Price Index (CPI)
The U.S. uses The Consumer Price Index (CPI), a measure of inflation. Bureau of Labor Statistics. It is updated monthly. Changes in the price of goods and services (e.g., energy, food, cars) are tracked and recorded. Because people may not buy the same “basket” of goods measured by the CPI, and because inflation affects people differently, the CPI may overstate or understate the true rate of inflation for individuals and families.
Median Income
The median is the exact halfway point (midpoint) in a distribution of numbers from the lowest to the highest.
In other words, half of the numbers are below the median and half are above it.
The median household income in the United States was $67,521 in 2020, down from $69,560 in 2019. Median income is typically used to report household financial status because average income figures are skewed by a small percentage of extremely high earners.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average is a price-weighted average of prices of stocks from 30 industry-leading U.S. companies. It is widely quoted each day at the close of market trading as a barometer of stock market activity. Because the DJIA uses such a small number of stocks, it is often criticized for not representing the entire stock market, which is why other indexes, such as the Standard and Poor’s 500 and Russell 3000, also are used.
Dollar-Cost Averaging
This term describes the process of investing the same amount of money on a regular basis regardless of market performance. For example, $100 in a mutual fund or 5% of pay every payday in an employer retirement savings plan. Dollar-cost averaging works best if investment deposits are “automatic,” such as authorizing 401(k) plan payroll deductions or automatically debiting a bank account monthly for mutual fund share purchases.
Buy and Hold
A long-term passive investing strategy where investors purchase stock, stock mutual fund, or exchange-traded fund (ETF) shares, particularly from companies with a history of steady earnings or growth, and keep them for a number of years regardless of market performance. Buy and hold investing can often outperform actively-managed investing because reducing trade expenses and capital gains taxes can suspend.
Time Diversification
The reduction in risk that often accompanies the lengthening of an investor’s time horizon.
What matters most in investing is not market timing, but time in the market.
Historical evidence indicates that long-term investing can reduce the risk of losing money and enhance potential returns. Time decreases the amount of volatility (i.e., ups and downs in prices) of investments. As the time frame increases to 15 to 20 years, extreme volatility flattens out.
Rule of 72
To estimate how long it will take to double a sum of money (any amount), at a given rate of return, divide 72 by the interest rate. For example, money will double in seven years at 10%, eight years at 9%, nine years at 8%, ten years at 7%, and 12 years at 6%. The Rule of 72 can also be in reverse to calculate the interest rate required to double money. Simply divide 72 by the specified time period. For example, 72 divided by 8 years = 9% interest.
For additional definitions of financial and investing terms, review this glossary from Rutgers Cooperative Extension.
