Chelsea: Hi guys, it's Chelsea from The Financial Diet here with our holiday friend Noodle. And today we're going to be explaining something that we haven't yet talked about, but which I think is very important when it comes to just generally feeling comfortable about money and that's defining some really basic finance terms, both kind of corporate finance and investing so that you feel confident using them and know what they mean when people bring them up in a conversation. So we're going to be talking about 9 different terms today starting with the first one, which is capital. Which is something you might have heard before and it's also something that you might think of as just being money. Like how much money a company has at it's disposal. 

Capital actually refers to the total resources a business has at it's disposal. Now that could be human resources, that could be financial obviously, that could be different properties that it has, whatever it has that can contribute to its overall value and to how much it can do. And obviously as a company grows, sometimes it might need to invest in more capital to help that growth, whether that be hiring a bunch more people or like when Facebook acquired WhatsApp. And often that will come from cash within the company, but sometimes a company has to look outside of itself to get that investment in the form of things like debt and equity. 

Now debt is something you've definitely heard of and chances are might living with yourself, so you probably already know to some extent that debt means a loan that needs to repaid usually with interest. Now debt can come in the form of bank loans or bonds and each one has different features such as the order in which they are repaid, or seniority, what rights the lenders have in regards to the asset of the borrowers, that's also called security, whether the interest is fixed or variable, and which legal provisions are included to protect lenders, now that's covenants in other terms. Now just like in the case of consumer credit, aka when you yourself are privately applying for a loan, the terms of a loan and how interesting they are for all parties is really based on a) the sort of credit worthiness of the borrower and b) current market conditions. 

Now debt security comes with the protections that lenders will be paid back before share holders if for example the company ever comes to bankruptcy and needs to pay everyone out. So generally debt security tends to be less risky than equity in that regard. Now in exchange for that preferential treatment and of course the general less riskiness of it all, that means that lenders generally will receive a lower, but more consistent return. Now while investing in individual debt is an option for retail investors, which is sort of the fancy word for people like you and me who might be investing, a lot of investors choose to go through mutual funds or exchange traded funds, i.e. ETFs, which place your money in sort of a diversified basket of bonds and loans to kind of spread it all out. 

Now equity is different and that represents a stack or share in a company that is sort of what you're entitled to when everyone is paid out. And, if we'll recall, after all debts have been repaid because the lenders get paid before the share holders. Now obviously this is kind of the fun, sexy, risky version of investment that we see on shows like Shark Tank, which I am personally obsessed with. And it definitely has that intrigue because obviously you're investment can grow really quickly or really hugely if the company does really well, but it also comes with a lot more risk. Because obviously those shares will be worth a lot less if the company is doing really poorly or, in the worst case scenario, will be wiped out completely if the company has to file for bankruptcy. 

So basically if you're comparing the 2, debt is the sort of slow and steady, we give you some money and you'll pay us back no matter what happens because you have to and equity is the more sort of fun, rollercoastery this could either go really well or really badly depending on how the company does, but it still feels cool. 

Now that brings us to things like primary issuance, which is when a company offers shares directly to investors. Now this can through an IPO or what's called a follow on equity offering or even directly to banks and then investors in the capital market. Now primary markets tend to be more volatile than secondary markets as everyone is kind of actively trying to establish the value of everything. Now secondary trading occurs when people buy and sell their shares to the market or "over the counter" through a broker trader. Now the vast majority of investments happens between investors themselves and not through the company itself.

And one thing that's important to consider here is that when people are buying and selling stocks, it's not always because "Oh this stock is doing badly, I gotta dump all my shares on someone else and cash out" it can be for any number of reasons. Maybe the person who has the stocks needs money at that point or their sort of changing up their portfolio, it could be for any number of reasons, but the stock market is not always based on "Oh, this is doing badly, this is doing well, that's how we're going to exchange things." And in fact it's kind of viewed as a good thing that there's all this sort of liquidity and action going on in the market. You know, with a reasonable amount because it means that if someone is looking to sell, there's probably going to be a buyer. And it also helps to drive along that auction process that keeps the values of the shares where they should be. 

Now a mutual fund is something we've probably all heard of, and one of those things that conjures images of old rich people. Now a mutual fund is an investment fund that is managed by a professional money manager who's job is to kind of put that investment into a diversified portfolio based on the goals and the strategies of that fund. Now mutual funds allow investors to invest in diversified portfolios that might otherwise be difficult with a small amount of capital and it allows you to benefit from the advice of a professional. Now there's a lot of debate whether passive or active investment is better and which one yields results, but there is a lot of compelling evidence that shows that several mutual funds have posted pretty impressive returns over the past decade, and we'll link to that in the description so you can read on it yourself. 

Then we have exchange traded funds or ETFs. And an ETF is an investments that typically tracks a stock or bond index or the value of a particular commodity. Now investors can buy and sell ETFs just like they would with common stocks and actually ETFs have become incredibly popular due to their high daily liquidity and their low costs. Now volatility is what measures how much a stock or other security has fluctuated in terms of value over time. Now this one's pretty self explanatory in the sense that something with high volatility generally is less easy to predict in the future and therefore considered a riskier option. But as we know investing is all about the trade off between risk and return.

And while something that is more volatile is obviously a more risky option it also offers that lure of potential bigger gains as well as bigger losses. And obviously more stable investments, less volatile, are more likely to offer more modest returns. And it's your job as the investor to determine how risk adverse you are. Do you want to take that risk for a potentially bigger reward? Or do you want to go with something that's going to be sort of slow and steady and modest. It might seem really vague and difficult to determine what your particular risk tolerance is, but there is a couple factors that are pretty universal. You have things like your timeline, your goals, and your current financial situation. I mean, realistically how much risk, you know, can you even take? 

Now we're going to include a few links in the description for a couple of questionnaires so you can figure out your own risk tolerance and decide what might be your own path for you in terms of investing. Now we're brought to diversification, which is that word that we are all sort of vaguely aware of, but no one really knows what it means even though we might use it sometimes. And diversification is that strategy of not putting all of your eggs in one basket, but in terms of the actually and strategy behind it, it's a little more complex than that.

Instead of just buying multiple stocks or securities, it's important to look at whether or not what you're buying moves in tandem with each other, i.e. if one thing goes bad, is everything going to go bad? So when people are seeking to decrease the volatility of their portfolio by diversifying, they're really looking at investing in things that perfectly correlate with one another and will therefore be a little bit less risky across the board. Because, obviously, in some regard you might have things that would go down, but another unrelated thing might go up. Now obviously this doesn't mean that a diversified portfolio means that it will never be down or that it will always be performing well. Because, at the very least, there's always going to be times when the market is down and therefore your portfolio is as well. 

But what diversification really helps with is that unsystemic risk, i.e. the risk that poor performance in one stock, or one company, or even just one region is going to really damage the value of your whole portfolio. Now investing is a lifelong skill and it's something that we all kind of have to develop as we go at our own pace, but one of the fundamental parts of getting confident with managing your own money and really getting into the world of investing is just knowing what these words mean. And instead of just kind of being scared of these words and avoiding them all together, we really recommend that you check out places like Investopedia, which we'll include a link to, which has definitions for basically any finance word you can imagine and can really help you get into that language of money. Anyone can be an investor, including, and perhaps especially, you. And as always don't forget to hit the subscribe button and go to thefinancialdiet.com for more. Bye!