Investing Basics: What You Don't Know Is Hurting You

Traders work at the New York Stock Exchange (NYSE) in New York, U.S., Photographer: Scott Eells/Bloomberg
Scott Eells/Bloomberg
Less than 1 in 5 Americans knows that an online brokerage account can be used to invest in stocks.

That's the upshot of a new study by the financial experts at NerdWallet, whose InvestingNerd division just ran a study concluding that "4 in 5 Americans (81.4 percent) surveyed could not correctly identify the type of account to open in order to trade stocks online."

NerdWallet? InvestingNerd? These hardly sound like serious organizations, but the financial literacy situation they describe is no laughing matter.

Check Out These Stats

In a national poll conducted from Feb. 9 to Feb. 12, 2013, NerdWallet asked 869 American adults a series of 10 simple questions on a range of subjects including brokerage accounts, asset classes, investing strategies, stock trading costs, trade execution, and 401(k) plan fees.

What they found was surprising -- and even a little frightening.

Asked quite simply what kind of account they should open in order to trade stocks online, 27.3 percent (230 interviewees) had no earthly idea what kind of account they needed. (And most of the rest got the answer wrong).
  • 2.1 percent would try to buy stocks with a bank CD.
  • 6.2 percent figured a money market account could do the trick.
  • 8.2 percent said they can trade stocks through their bank savings account.
  • And 13.3 percent said "none of the above," meaning they ruled out the correct answer (a brokerage account), which was one of the options.
On the plus side, 18.6 percent of Americans did know that an online brokerage account was the correct way to trade stocks online. On the minus side, those 18.6 percent were vastly outnumbered.

Laughing All the Way to the Bank

Not everyone's upset with the results of this study, though. Fact is, a lot of people on Wall Street depend on our ignorance about the basics of investing -- and even make a living off our inability to invest for ourselves.

Studies show that as many as 80 percent of actively managed mutual funds underperform the average return on the stock market in any given year. Paid financial advisors routinely charge 2 percent (or more!) of any assets you hand them to manage. That's 2 percent of your money, vanishing, each and every year you give it to the pros to "manage" -- whether or not they earn you a profit. And if you happen to be rich enough to buy into a hedge fund, they can cost you even more.

What it Means for You

So what's the alternative? If you're not one of the 18.6 percent who already knew how to invest without calling a professional, it's time to join them. By opening a low-cost, online brokerage account, you should be able to at least match, and probably even beat, the pros at their game -- and do so at a cost measured in only tens of dollars a year.
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How? It's simple. If so many financial "professionals" are turning in performances worse than the average returns on the stock market, then you can beat them simply by matching the market's returns. The easiest way to do this is to open an online brokerage account, and buy yourself a few shares of a simple, low-cost index fund or index-fund imitating ETF -- such as the SPDR S&P 500 (SPY) ETF or "Diamond" SPDR Dow Jones Industrial Average (DIA) ETF.

You can do a lot more than just buy plain-vanilla index funds and index ETFs once your account is open, of course. But if you can beat 80 percent of mutual fund managers, and even more hedge fund managers, with this single, easy step -- that's a good day's work already.

Ready to get started? Head over to the DailyFinance Investor Center for more information.

Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.

Financial Terms You Need to Know
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Investing Basics: What You Don't Know Is Hurting You

In a nutshell, net worth is what you get when you subtract liabilities from assets -- what you owe from what you own. Like many economic and financial terms, net worth can apply in a variety of situations.

If you're evaluating a company for your portfolio,you might glance at its balance sheet to get a handle on its net worth. Balance sheets break out assets (such as cash, inventory, and receivables) and liabilities (such as debt and accounts payable). Subtracting the latter from the former gives you net worth, which is also referred to in this context as shareholders' equity or book value.

Here's an example: As of the end of 2012, IBM's (IBM) assets totaled $119 billion, and its liabilities totaled $100 billion. Thus, its net worth, or shareholders' equity, was $19 billion.

Read more on Asset Allocation.

You probably think you've got the term down pat: Inflation means prices rising over time. Well, yes, that's pretty much right. But there's much more to inflation, and it's much more relevant to your life than you might think. Inflation can go in the opposite direction, for example, and it can spiral out of control.

Inflation is about purchasing power. It's a way to measure the changing purchasing power of our currency by tracking changes in the prices of things we buy. The national banks of various countries try to keep inflation under control through their actions and policies (such as via the interest rates they set); many aim for an annual inflation rate of about 2 percent to 3 percent.

While the concept of inflation seems simple it's actually a bit more complicated. Read more on inflation here.

Most of us are familiar with the term, and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it's a like a quantified pros-and-cons list.

Applying cost-benefit analyses in the business world and your own personal finances can be very effective, helping decision makers avoid just going with their gut or with very rough calculations.

Read More About Cost-Benefit Analysis

Simply put, it's what you give up in order to do something. Imagine, for example, that you dream of becoming an engineer or a chef. If you opt to become a chef, you give up the experience of being an engineer and all that goes with it. That's an opportunity cost of becoming a chef.

Opportunity cost is also often defined, more specifically, as the highest-value opportunity forgone. So let's say you could have become a brain surgeon, earning $250,000 per year, instead of a chef earning $50,000. In that scenario, your opportunity cost, salary-wise, is $200,000. (Of course, you should also consider factors such as your enjoyment of your chosen profession.)

Read more on Opportunity Costs.

Most folks are familiar with the concept of supply and demand, but most of us also don't give it much thought, which is a mistake. That's because it applies to much more than just business.

First, to review. In basic economics, the law of supply and demand influences prices. If supply of an item is abundant, that will pressure the price downward, and vice versa. In practice, imagine that you're the only one in town selling shoehorns. Because consumers don't have any other places to buy the product, that gives you some pricing power. But if other stores in town start carrying shoehorns, you may have to drop your price to keep customers coming.

Read about the differences of supply and demand in the stock market and in our own lives here.

As the name suggests, sunk cost refers to money that has already been invested in something, money that can't be recovered. Too often, we factor that expense into our financial decision-making when we shouldn't.

Let's say you've spent $40 on a nonrefundable ticket to the theater for tomorrow night. And you're suddenly invited to play board games at a friend's house that same evening. You might think that you should go to the theater -- after all, you spent that $40 -- even though what you'd rather do is hang out with your friends and play games. The $40 is a sunk cost. It's spent, whether you go see the play or not, and the money doesn't know the difference. So you should do whatever you would rather do.

Read more on Sunk Cost.

In the most basic sense, asset allocation is simply how one's assets are divided among different asset classes, such as cash, stocks, bonds, real estate, and so on -- even insurance investments, commodities, collectibles, and other categories count.

But the term also refers to an investment strategy -- one that can reduce risk through diversification.

Clearly, having all your money in any one asset class can be risky. In 2008, the S&P 500 plunged 37 percent. If you'd held all your assets in an S&P 500 index fund, your net worth would have taken a big hit that year.

Given the harrowing ride we've been on in recent years, you might think that holding cash is the best way to protect your assets from outside forces. Think again.

Continue reading about Asset Allocation.

The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.

But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.

First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.

Enter compound interest, which is far more exciting.

Continue reading on Compound Interest.

The meaning of the term varies depending on context. In the accounting world, for example, it refers to the change in a company's cash level over a specific period of time. If a company's cash level rises during that period, it's exhibiting positive cash flow. If it shrinks, negative cash flow.

When investors study companies to see if they might be good fits for their portfolios, they may assess "free cash flow." That reflects a company's cash flow from its operations after it pays all its expenses. Free cash flow can be viewed as the lifeblood of a company.

Read more on Cash Flow.

When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.

The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.

At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.

Learn more about Risk and Return.

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