Broker Check

Learning a New Language: Commonly Misunderstood Financial Terms

| June 14, 2017
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Navigating the financial world can be challenging for even the savviest investors, but for those new to financial planning, truly understanding the course they are about to chart is vital. It begins with learning the language spoken in the financial world. While many consumers have heard common financial terms before, their definitions are often unclear – some terms take on new meaning when applied specifically within the financial world. 

Whether they are seasoned investors or just starting their financial journey, the following terms are among the most commonly misunderstood by consumers:


Investment Income vs. Distributions

While both terms refer to “getting” money, the nature of the “get” is different. Income can be made up of dividends or interest generated from investments, which are often used to purchase additional holdings. They’re usually not distributed directly to the account holder. Because it is often immediately reinvested, investment income can be a tricky concept when considered in a portfolio or mutual fund. When an account receives income, it typically does not change the total value of the account, as the underlying holding’s market price accounts for the income that is due. The market price of the holding will drop once it has paid income.

In contrast, distributions are funds the account sends to its holders. Distributions may be the result of investment income or the sale of holdings. The tax impact of distributions and income depends on the type of account, source of income, and other factors.

Growth vs. Gains

Growth is another concept that is sometimes confused with income. Growth reflects an increase in the market price of the holdings, while gains come in when holdings are sold. If a holding has experienced growth since it was purchased, but has not been sold, it has an unrealized capital gain. Once the holding is sold, the gain turns into a realized capital gain. The tax impact of a realized capital gain depends on several factors, including the type of account and the time from purchase to sale.

Decline vs. Loss

A decline occurs when a holding’s market price decreases over time. A decline does not necessarily mean that the holding’s value has fallen below its purchase price.

Losses come into play when the holding is sold for a price that is lower than its original purchase price. A portfolio only experiences a loss if the holding is sold at a price that is lower than its original purchase price, also known as a realized loss. If the holding has experienced decline and has not been sold, it has an unrealized loss.

The tax impact of a realized loss depends on several factors, including the type of account and the time from purchase to sale.

Volatility

While growth of investments is not guaranteed, it is possible to track both the average rate of growth and how much returns vary from the average. This measurement of how much growth varies is called volatility. If you think of a typical chart outlining the value of a portfolio, the volatility would be a measurement of the fluctuation in the line showing growth over time—essentially how much the line “wiggles.” In math terms, the greater the changes in the slope of the line, the more volatile the investment.                                   

Risk

Volatility is often considered one of the components of risk. Risk can be the amount of money you could lose in a worst-case scenario or simply the probability that an investment decreases in value. High-risk investments can experience periods of low volatility, while low-risk investments can experience periods of high volatility. For example, federal government bonds are low-risk investments, but they can experience periods of high volatility.

Insurance Premium vs. Cost of Insurance

Insurance premiums are the regular (often monthly) payments from the contract holder to the insurance company. The cost of insurance is how much the insurance company charges you for insurance each month versus how much you are insured for—essentially it is the net cost of the insurance. For term insurance, the cost of insurance and the insurance premium are the same. For other types of insurance, the cost of insurance and the premium are usually different.

Fiduciary

A fiduciary is simply an individual who is required to act in the best interest of their client. Many industries use the term fiduciary, but it carries many misconceptions. In financial services, this means that an advisor is required to choose the investments they believe are best for the client. Depending on the type of account a client has, an advisor may or may not be legally bound to act as a fiduciary.

The term fiduciary does not refer to a title or certification, but a standard. There is no central organization that has authority over all fiduciaries in all industries, but it is common that those with professional credentials are typically held to fiduciary-like standards by their credentialing organizations.  

The CFP Board Standards of Professional Conduct require that all CERTIFIED FINANCIAL PLANNER™ professionals who provide financial planning services will be held to the duty of care of a fiduciary. The CFP Standards also require that CFP® professionals place the interests of the client ahead of his or her own at all times. Certified Public Accountants (CPAs) are also held to similar standards in accordance with the American Institute of Certified Public Accountants’ (AICPA) Code of Professional Conduct. 

Led by experienced, credentialed professionals, Pinnacle Financial Advisors has always held its team to the highest standards, with the interests of our clients at the core of our practice.

Investment Adviser vs. Financial Advisor; Financial Advisor vs. Financial Planner

Investment Advisers, Financial Advisors and Financial Planners are three distinct professions each carrying different legal implications. Investment Advisers advise purely on investments – what to buy and what to sell. While they can make those recommendations based on a client’s overall financial picture, their focus is primarily on the investments and not the client’s finances as a whole.

Financial Advisors, depending on their license, take the client’s entire financial picture into account before making recommendations. They may or may not advise on the individual investments to be selected.

Financial Planners take it one step further, developing a plan of action for now and into the future, including paths for multiple possibilities in the client’s life. While some Financial Planners are involved only in the creation of a financial plan, others continue to work with a client through the plan’s implementation. A financial professional may be acting in one or more of these roles for a client.

Investment Advisers or Investment Adviser Representatives can become registered through the Securities and Exchange Commission (SEC) or via a state securities regulator. But they can choose to become a CERTIFIED FINANCIAL PLANNER™ professional through the Certified Financial Planners Board of Standards. At Pinnacle Financial Advisors, our full-service team is made up of a wide variety of professionals who are able to meet the diverse needs of our clients. 

While we don’t expect our clients to be experts in financial lingo (that’s what we’re here for!), it’s a good idea to familiarize yourself with common financial terms so you can better navigate your financial future.

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