Investing Definitions
Because people on your committee may have varied expertise regarding finances, the following definitions, used when discussing investments, have been compiled. The following definitions are intended to provide general information and are not intended to be inclusive.
Q: What are assets?
A: Assets are possessions/holdings and in this context refer to any resources that are readily marketable and whose fair market value is measured in dollars.
Q; What are asset classes?
A: Asset classes are categories that describe types of assets. For instance, Equities, Fixed Income Securities, and Real Estate are asset classes.
Q: What is a portfolio?
A: A portfolio is a collection of assets, usually held and accounted for by a “custodian” such as a bank or brokerage house.
Q: What does asset allocation mean?
A: Asset allocation describes the relative percentage of asset classes in a portfolio. An organization determines what percentage to assign each asset after determining its own objectives for the investments. Target asset allocation sets a standard to which allocations can be compared.
Q: What do fixed income assets represent?
A. Fixed income securities (money market accounts, certificates of deposit, and bonds) are promises by a business or government organization to pay a fixed amount of income for a specified time period and, at maturity, return the original investment. Examples are U.S. Treasury notes, corporate bonds, and commercial paper. Bond mutual funds are considered fixed income investments.
Q. Why are fixed income assets held in a portfolio?
A. Fixed income assets usually offer relative stability of principal and generally low to moderate levels of risk, and generate income that can be paid out for income-only spending policies.
Q. What do equity assets represent?
A. Equity represents ownership in a corporation. Equity assets are investments in shares of stock, each of which represents a portion of the corporation’s ownership. Within the equity asset class are several subclasses, such as large, medium, or small capitalization companies, foreign companies, and so on. Stock mutual funds are considered equity investments.
Q. Why are equity assets held in a portfolio?
A. Since the value of a company can grow or shrink, a percentage of ownership in the company (a share of stock) can grow or shrink in value. The potential for growth is important to protect a portfolio against inflation and to provide real growth over time. An investment in equities contains risk, which is determined by the size of the company and measured by the volatility of its stock price.
Q. What should one consider when making choices about asset allocation?
A. The considerations vary depending on the goals and objectives that the organization has for the uses(s) of the money, time horizons, and size of the portfolio. Short-term portfolios that place importance on the preservation of value or higher income may require larger allocations to fixed income securities. A portfolio with longer time horizons and more tolerance for short-term fluctuations or less dependence on producing income could have a larger allocation to equities.
Q. What is investment policy?
A. An investment policy is a written set of instructions to guide the way in which an organization manages its assets. Investment policies are specific to each individual organization and goals and objectives, and reflect risk tolerance, time horizons, and how and when the money is intended to be used.
Q. What questions should one ask when establishing an investment policy?
Should the account maintain its purchasing power (inflation protection)? Is income important? What is an acceptable level of risk for fluctuations in portfolio value? What is our time frame? Short and long-term horizons call for different approaches.
Q. What is spending policy?
A. A spending policy determines how the money in an account will be withdrawn and what it will be used for. Will it be a percentage of the portfolio’s annual market value? Will it be a specific dollar amount? Will withdrawals be limited only to the income earned by assets? Will the uses to which the money is put be restricted to outreach or outside-the-parish ministries?
Q. What does rate of return mean?
A. Rate of return is the percentage by which the value of a portfolio’s assets has changed over a specified period of time, usually a year. Generally there are three types of returns: income return, capital growth, and total return. Income return comes from dividends on equity assets and interest from fixed income assets. Capital Growth comes from a change in the value of equity assets resulting from changes in market price. Total return represents the combination of both.
Q. What is an income only spending policy?
A. An income only spending policy calls for the portfolio to pay out periodically all the income earned by the assets (dividends on stocks or mutual funds and interest on fixed income assets) regardless of the amount of capital appreciation or loss.
Q. What is a total return spending policy?
A. A total return spending policy is one in which the combination of income earned and the change in capital value is taken into account when determining how much to draw from a portfolio over a specified time period. For example, if All Saints’ Church were to adopt a 5 percent spending policy, each year the parish would draw down a distribution worth five percent of the account’s market value. Though the income of the portfolio may have been less than five percent, the fund may have appreciated 8–10 percent during that year, so the total value of the portfolio at the end of the year is still greater than it was at the beginning of the year.
Q. What is market capitalization and how is it determined?
A. Market capitalization measures the value of a corporation and is determined by multiplying the market value of a company’s shares of stock by the number of shares outstanding. “Large capitalization” or “Large cap” stocks are generally considered those of companies with a market capitalization of more than $1 billion. “Mid cap” and “Small cap” stocks also are considered asset sub-classes.
Q. What is an “index”?
A. An index is a measure calculated by compiling the market prices of securities of a particular asset class or sub-class. The rise and fall of the index establishes a benchmark to which the performance of similar securities can be compared. Different indexes represent different types of markets: The S&P 500, for example, represents certain large cap U.S. stocks. The Russell 2000 represents smaller and mid-cap stocks. In order to properly capture the market returns, smaller companies do not necessarily impact the index the way a larger company might. So, in some indexes, the value of some securities is “weighted” more than others, usually in relation to their market capitalization.
Q. What does it mean to rebalance a portfolio and why is it important?
A. Because the value of one asset class will fluctuate more or less than another, asset values will, over time, fluctuate from the target asset allocation. When the value of different asset classes has changed to such an extent that it represents a percentage more or less than the range intended, the manager moves assets from one class to another to return the portfolio to its original allocation percentages. It is important to rebalance the portfolio because target allocations reflect return objectives and risk tolerance decisions made in establishing the investment policy. Significant deviation from those targets results in different return and risk characteristics.
Q. What are long-term and short-term time horizons?
A. The Episcopal Church Foundation in West Texas uses five to seven years when considering a long-term time horizon and one to four years for a short-term horizon.
Q. How does an organization determine what type of risk it can tolerate?
A. Decisions about the types of risk an organization can accept should be based on current and future needs, not on the personal preferences of committee members. For example, a portfolio that provides resources for annual scholarships might have a lower risk tolerance than long-term endowment assets. The two portfolios might, therefore, require different asset allocations.
There are various risks inherent to investing, ranging from inflation (erosion of purchasing power) to loss of principal. Different investments and asset classes have different degrees of risk.
Risks can usually be reduced over time. While equity returns are often volatile over short periods, history has shown that equity values have increased over the long term. Therefore, organizations that cannot or should not tolerate significant short-term fluctuations should not allocate significant portions of their portfolios to equities.
Adapted from Funding Future Ministry
