While details of daily market activity have recently gone from the business section to the front page, most people's basic investment vocabulary remains limited at best.
While "scandal," "market volatility" and "fraud" are common buzzwords, fundamental investment terms commonly return blank stares and off-the-mark definitions.
I asked business professionals, students and other folks on the streets of Chicago about basic investment terms. Most of the people I spoke with were unable to explain what the everyday investment terms really mean.
Are you financially literate? Check out the terms and definitions below.
What is the S&P 500?
Standard & Poor's was originally established as a financial analysis company in 1860 and is still in operation today. Introduced in 1957, the Standard & Poor's 500 Index is a composite of 500 leading companies that is widely regarded as a standard for measuring U.S. stock market performance — specifically, large companies. This popular index includes many well-known, household names like Home Depot, Proctor & Gamble and Johnson & Johnson. The biggest company in the S&P 500 Index is General Electric. Even though we are inundated with news about the Dow Jones Industrial Average, the Dow is comprised of just 30 large companies like AT&T, Exxon Mobil and Boeing. With 500 stocks, the S&P 500 is a much broader index. As such, most money managers are more likely to watch the S&P 500 when gauging the movement of the market. In fact, the S&P 500 is used by 97% of U.S. money managers and pension plan sponsors and over $1 trillion in investor assets is indexed in the S&P 500.
What is a bear market? A bear market is when there is a general fall in stock prices. Although figures vary, the classic definition of a bear market is a 15 percent drop in the value of the stock market that lasts for more than six months. Conversely, when stock prices rise, it is known as a bull market. No one is really sure where the terms came from, but one theory is that bulls buck up their horns to kill their prey, whereas bears "bear down" with claws and teeth and also hibernate in the winter.
What is a bond? Stockholders are part owners of a corporation, sharing in both its good and bad fortune, whereas bondholders are serving only as lenders who expect to be repaid. That's why bonds are called debt securities — they are essentially IOUs. Because bonds typically pay interest over time, they are also known as "fixed income." Bonds typically carry less risk than stocks. In the event of bankruptcy, bondholders are paid first, then stockholders. Here is an example illustrating the difference between bonds and stocks. Bob wants to open a restaurant. He asks his brother Jim to invest in the restaurant, so Jim is like a stock investor. As an owner of the restaurant, Jim is subject to both the ups and downs of the business. Bob also asks his sister Mary to lend him money to help start the restaurant, so Mary is like a bond investor — she expects to be repaid. Mary will not make as much money as Jim if the restaurant is a great success. However, because she is simply lending money, if the restaurant goes bust, Mary will still get her investment back, just like Bob would repay a bank.
What is an IRA? IRA stands for Individual Retirement Account. It enables an investor to save for retirement while reaping a myriad of tax benefits. These benefits range from obtaining a deduction on the money you save to compounding your money tax-free for decades. Recent changes to the tax laws have raised contribution limits, making IRAs even more attractive investment opportunities, so be sure you are maximizing your contributions. Traditional IRAs allow investors to make tax-deferred investments. While contributions are often tax-deductible, all withdrawals on Traditional IRAs are taxed, and early withdrawals are also subject to a penalty tax. First offered in 1997, Roth IRAs allow taxpayers (subject to certain income limits) to invest for retirement and allow the savings to grow tax-free. Investors pay taxes on their Roth IRA contributions, but withdrawals, subject to certain rules, are not taxed at all.
Contribute early —and often: If you were to contribute $2,000 each year for 30 years: Value with an IRA = $297,150 Value with a taxable account = $183,290 Difference = $113,860 This example shows the benefits of tax-advantaged growth in an IRA — a total of $113,860 more over an identical investment. Our example assumes a 28 percent tax bracket and an earnings growth rate of 9 percent annually. Note that earnings and deductible contributions withdrawn from a Traditional IRA will be taxed upon withdrawal.
Mellody Hobson, president of Ariel Capital Management in Chicago, is GoodMorning America's personal finance expert. Click here to visit her Web site, Ariel Mutual Funds.com. Ariel associate Matthew Yale and Ariel's Director of Corporate Communications Anne Roche contributed to this report.