At Sound Mind Investing, we have a commitment to clarity. As we say on our mission/vision page, "We tell you what you need to know, not everything there is to know." And we try to do so in simple language, avoiding (as much as possible) investing jargon that the average person may not know.
Still, some terms are almost unavoidable because they crop up somewhat regularly in news accounts and market commentary. So to further your "investment education," here are a few such words and phrases, along with simple explanations.
• Basis point. This term is used frequently in news reports about interest rates. Here's a definition from Morningstar:
A basis point is one-one hundredth of a percentage point.... [Therefore,] one hundred basis points is 1%.
Basis points help easily explain tiny percentage changes. For instance, if the Federal Reserve lowered interest rates by a quarter of a percent, you could express that as 25 basis points.
What's it worth?
Four times a year, companies report their previous-quarter earnings during "earnings season" (we're in the first-quarter earnings season right now). Mutual fund managers and stock investors pay particular attention to two specific metrics related to earnings. The first is:
• Earnings per share (EPS). From Nasdaq:
A company's profit divided by its number of common outstanding shares. If a company earning $2 million in one year had 2 million common shares of stock outstanding, its EPS would be $1 per share.
A stock's price is then gauged in relation to its earnings to determine if a stock is over-priced or under-priced — and by extension, taking into account thousands of stocks, whether the overall market is overpriced or underpriced. The comparison of price-to-earnings is called (you guessed it) the:
• Price/Earnings (P/E) Ratio. More from Morningstar:
[The] P/E Ratio is a valuation metric that assesses how many dollars investors are willing to pay for one dollar of a company’s earnings. It's calculated by dividing a stock's price by the company’s trailing 12-month earnings per share from continuous operations.
A high P/E usually indicates that the market will pay more to obtain the company's earnings because it believes in the firm's ability to increase its earnings.... A low P/E indicates the market has less confidence that the company's earnings will increase; however, a fund manager or an individual with a "value investing" approach may believe such stocks have an overlooked or undervalued potential for appreciation.
It's worth pointing out that this year's first-quarter numbers may not mean much, given the unprecedented economic upheaval caused by the coronavirus pandemic — an upheaval that began near the end of the first quarter and then unfolded with much greater force as the second quarter got underway. (Also, we should note there is more than one approach to calculating P/E ratios, as SMI's Mark Biller detailed in 2017 in The Truth About P/E Ratios.)
• Priced in. The Wall Street Journal offered an "explainer" about this term last week (the article is behind the WSJ paywall):
["Priced in" describes] the way investors’ expectations move financial markets.... Investors look at likely future events to adjust how much they are willing to pay for stocks or other assets....
In general, new information quickly gets reflected in financial-market prices, giving us a sense of what investors as a whole are thinking about the future for business and the economy. But of course that sentiment can reverse quickly as new information becomes available.
During the Covid-19 panic, investors quickly priced in an extremely weak economy for the immediate future. From Feb. 19 through March 23, the S&P 500 index fell 34%.... But stocks then began a rebound that would see the S&P 500 halve its losses over the next two weeks, as investors priced in a less severe economic downturn, thanks largely to fresh support from the Federal Reserve.
Two investing approaches
Here are two terms that describe particular methods for trying to "beat the market" — i.e., attempting to outperform a broad-market benchmark, such as the S&P 500. The first term isn't all that common, but I saw it a couple of weeks ago (without any kind of definition) in a post by a widely read investing blogger.
• Fading the market (or fading the crowd). Here's a definition from Investopedia:
"Fading the market" is typically a high-risk strategy and is usually deployed by seasoned traders.... A trader who fades would sell when a price is rising and buy when it's falling. The premise behind a fade strategy is that the market has already factored in all information and the latter stages of a move is powered by traders who are slower to react, thus increasing the probability of a reversal.
In essence, "fading the market" is the opposite of "trend-following." (SMI's "momentum" approach is based on trend-following, not on making predictions about possible changes in market direction.)
Market-timing. From Vanguard:
An investment strategy based on predicting market trends. The goal is to anticipate trends, buying before the market goes up and selling before the market goes down.
Market-timing tries to get out in front of trends and catch the full ride up (and later avoid the ride down). It's an appealing theory. But as we noted in our October 2019 issue, even if practiced perfectly (which is all but impossible!), market-timing yields a surprisingly small benefit relative to just making steady investments through all of the market's ups and downs.
In the know
Every field has "in-house" terminology, and investing is no different. In fact, in researching this post, I came across literally hundreds of terms and phrases most of us will never use and don't need to know (from "Absorption" to "Zero uptick").
As noted above, at SMI we try to keep things as simple as possible. Even so, it does help to be familiar with terms that show up regularly in the press, and perhaps with a few lesser-known bits of jargon that investing bloggers and pundits sometimes use.
That's all for today. Class dismissed!