Decoding More Investing Jargon

One of the fascinating things about investing is that, at times, it seems to have a language all its own. To the uninitiated, reading the financial press--and, in some cases, this website--can feel like reading a version of English from an alternate universe--the words are familiar, but the meaning is anything but clear.

That's why, from time to time over the past year, we've asked readers to send us examples of financial terms and jargon that they don't understand, or at least don't understand well. The response has been strong, and we've taken on many of your suggestions in previous Short Answer installments (found here, here, and here).

So, without further ado, let's get into our latest batch of jargon stew.

Compound Annual Growth Rate (CAGR): Method of measuring a company's growth rate over time that smooths out lumpy returns. For example, let's say a company earns $1 billion one year, $1.2 billion the second year, $1.8 billion the third year, and $2 billion the fourth year. The company's growth in years two, three, and four represent gains of 20%, 50%, 11%, respectively, from the previous years. The compound annual growth rate for the company over those years is 26%, which represents what its rate of growth would have been had those earnings been consistent over that time frame rather than the lumpy reality. CAGR can be particularly useful in examining the rate of growth for companies with inconsistent or volatile growth patterns.

Credit Default Swap:

Financial instrument (technically a derivative) in which one party agrees to take on credit risk from a fixed-income investment on behalf of another party for a fee. Typically, the buyer of a credit default swap does so for insurance in case the issuer of a bond that the buyer owns defaults on that bond (in other words, the bond issuer is unable to make the payments it has promised). The seller of the credit default swap agrees to make up any shortfall in the bond payments if the bond issuer defaults and receives periodic payments (typically a portion of the income generated by the bond) as compensation. Credit default swaps played a key role in the 2008 financial crisis as the rising number of mortgage defaults proved costly for firms that had sold credit default swaps against them, most notably insurance company

Dark Pools: Private investment exchanges run by financial institutions in which trading orders are not made public, as they are with the New York Stock Exchange or NASDAQ. This lack of transparency has given rise to the name "dark pools." Institutional investors may use dark pools to execute large trading orders so as to secure a better price than they can get on public exchanges, to keep other investors from front-running (trading shares with the advance knowledge of other orders that are in the pipeline), and/or to save on costs. Dark pools have come under increased scrutiny by the SEC lately due to transparency concerns.

Fiscal/Monetary Policy: Fiscal policy refers to a government's use of its revenues and expenditures to influence the economy. Examples include the federal government's enacting of a stimulus program (spending) aimed at boosting employment or the implementation of tax cuts designed to pump more money into the economy. Monetary policy refers to control of the money supply and interest rates by the Federal Reserve, typically to influence the rate of price inflation and to help combat unemployment.

Hurdle Rate: Rate of return required by an investor to justify the amount of risk the investor is taking. The term can be used rather broadly to represent a point at which an investment is considered worthwhile.

Margin: Borrowing done in order to buy securities. Investors may buy stocks on margin through their brokerage, for example, if they prefer not to use their cash to buy them outright. However, the investor will be charged interest on the loan and face the risk of a margin call--the right of the lender to demand some or all of the money it is owed at any time.

Oversold: Investment slang for a stock that is selling at a deep discount to its actual worth. It's a way of saying that too many investors have sold the stock, pulling its price down. Conversely, a stock whose price is higher than it deserves to be may be described as "overbought." Both terms also can be applied to the market as a whole.

Transparency: The degree to which a company or institution is willing to make public information about its workings. In the wake of the financial crisis, many politicians and commentators have called for increased transparency from the financial-services industry.

Visibility: The degree to which a company's future performance can presently be seen. For example, a firm may have good revenue visibility because of a long-term contract with an important client.

Weighted Average Cost of Capital (WACC): A measure of a company's cost of capital (the amount it must pay to finance its assets) weighted proportionally by source. So, if 60% of a company's capital costs come from equity it has issued (for example, dividend payments to shareholders) and 40% comes from bonds it has issued (for example, bond interest), these percentages are weighted accordingly to determine the company's average capital cost.

Yield Curve Roll-Down: The change in the price of a bond as its maturity date gets closer--in other words, as it rolls down an upwardly sloping yield curve. For example, as a five-year bond with a yield of 2% gets closer to maturity, it begins competing on the open market with bonds with shorter maturities and lower yields, thus boosting its price. So, if brand-new three-year bonds are paying 1% and the five-year bond has only three years left until maturity, the price of the five-year bond will increase accordingly to account for its higher yield (2%). This example is based on the yield curve sloping upward, which is usually--though not always--the case. In a downward-sloping yield curve, the opposite of what's described here would occur, with the bond's price losing value as its maturity date gets closer.

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