Two strikes against investment jargon

As investment managers, we too often think that a vocabulary laced with financial investment jargon will make us appear “in the know.” Our industry’s talk track overflows with “beta,” “alpha,” “risk assets,” and on and on. It’s a shame – we best serve our clients and offer real insight when we are clear, direct and use plain language. Making investing easy to understand is something I tackle in my recent video series, Successful Investing is Hard.

For me, two words stand out as the leading culprits in this addictive cascade of investment jargon. Investment advisors use these words too frequently, with too little regard for investors’ understanding. Let’s strip away the obfuscation (sorry, confusion).

1. “Hedge” is a word that gets tossed more than optimistic soccer bets during World Cup season. Financial hedges originated in agriculture. If I grow corn, I can protect myself from price fluctuations by locking in a price with a buyer, let’s say Kellogg’s®, the maker of Kellogg’s Corn Flakes®. Before I even plant a seed, I might agree to sell all my corn to Kellogg’s for $5 a bushel. This could be vitally important, say if corn prices were to fall to $3 a bushel and at that level I could lose my farm.  I have hedged that risk. On the other hand, if corn jumps to $7, I sacrifice some reward but at least I am guaranteed enough to cover my expenses and make some profit.

On the buying side, Kellogg’s gets the mirror image of that equation in terms of potential loss/gain. As buyer, they lose money on Corn Flakes if they have paid $7 a bushel to make money at $5 a bushel. The key thing to remember about a hedge: It’s often better to make a little rather than losing more than you can afford. Hedges lower the possible profit on an investment, but  can help protect against the potential of a much greater loss.

2. “Fundamentals” is an over-used term that invites confusion. I will define it simply as “profits.” Over the long term, stock prices are ultimately driven by how much money a company earns. Companies with higher profits and those that are likely to be able to earn still higher profits in the future are “fundamentally” more valuable than companies with lower profits or those unlikely to generate lower profits in the future.

In turn, fundamentals influence price-to-earnings (P/E) ratio, a number that simply tells you how much the market is willing to pay for $1 in current earnings. Companies with higher P/E ratios are generally expected to generate higher future profits than companies with lower P/E ratios. Early in a year, for instance, investors may be willing to buy a company stock for $14, based on the company’s earnings of $1 per share – a 14:1 P/E ratio. But if investors are confident that company is going to make a lot more money in a year or two, they may bid the share price up to, say, $17, for a 17:1 ratio. It’s a way to buy the company’s future potential earnings, not its present earnings.

Other factors that affect a company’s future profits include how well the company is run, its competitive advantages, future growth of its customer base and whether the economy is likely to expand or contract. All of these are often considered “fundamentals,” but in the end, profit is the ultimate fundamental.

So there you go – two strikes against the jargon stream. It’s a start.

For more on how some of these jargon terms arose in the industry, you may want to download Great moments in financial history. It is a booklet about some of the key moments in financial history from 3000 B.C. to 2012.