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Expand Your Investing Vocabulary

U.S. News and World Report Smarter Investor

A breakdown of commonly used investing terms and how to make sense of them all.

With the closing of the first quarter and the beginning of National Retirement Week next week, the news is filled with stories about the economy, the direction we are heading, and predictions for the future. While the coverage is insightful, the stories are typically ridden with financial jargon that, for many, sounds like a different language. To help simplify things, here is a breakdown of commonly used terms, and how to make sense of them all:

Earnings.

The direction of a company’s earnings and the rate of change for those earnings are pretty reliable indicators of the direction of the company’s stock price. If the earnings are improving, especially at a rate faster than analysts expected, you should see some appreciation. On the other hand, if a company’s earnings fall short of expectations, be prepared for a downward move in the stock price.

Asset classes.

To have a diversified portfolio, one should invest in various asset classes as well as different size and style boxes. Asset classes are generally defined as equity, fixed income, and alternatives. Style boxes (made popular by Morningstar) classify equities by large cap, mid cap, small cap, growth, blend, and value.

Economic cycle.

Where we are in an economic cycle is usually a debated topic that does not get resolved until the next phase is well under way. For instance, it is almost impossible at this point to say where we are exactly in the current cycle, other than to say we are not at the beginning.

How to use this investing vocabulary

How can you use this information to improve your odds of having a successful portfolio? Using history as a guide and looking at current price-earnings ratios (P/Es) as well as future P/Es, some interesting information comes to light.

According to J.P. Morgan, and based on the S&P 500 closing price of 1,258 as of Dec. 31, 2010, the average P/E was 13.1x, meaning the price of the S&P 500 was 13.1 times greater than the earnings of the S&P 500.

The average over the last 18 years has been approximately 16.5x earnings. This shows us that stocks are relatively cheap compared to their historic average. Goldman Sachs’ prediction that the S&P 500 could increase to more than 1,500 this year would leave the P/E of the index at approximately 13.5x forward earnings over the next 12 months based off of the S&P at 1,290 as of March 22.

Once you understand the meaning of the above terms and how they influence the market, you can use them to help figure out what investments may be suitable in a given market. For instance, look at P/Es as of the end of last year by style box according to J.P. Morgan, and you will find some significant differences that can help you identify areas that are potentially undervalued.

My analysis of this data has shown that small-cap and mid-cap value style boxes are trading at 99.4 percent and 94.6 percent of their 20-year historical averages. The next highest was small- and mid-cap blend with mid blend at 91.5 percent and small blend at 93.9 percent. Compare that to large growth at 69.2 percent, large blend at 78.8 percent and large value at 84.9 percent, and one can surmise that maybe it’s time to take some money out of small companies that have outperformed over the last two years and head towards the large-cap names as we move through 2011.

To sum it all up, I am anticipating another solid return for equities this year if earnings stay on track. Keep in mind earnings season is about to begin. I suggest investors consider a strategy that increases an allocation to large-cap growth when evaluating their next move.

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Monument Wealth Management in Alexandria, Va., is a full-service investment and wealth management firm, and Registered Investment Advisor. Monument Wealth Management has been featured in several national media sources for the past several years. Tim and Monument Wealth Management can be followed on their blog at Off The Wall , their Twitter account @MonumentWealth and on their Facebook page.

Securities offered through LPL Financial, Member FINRA/SIPC.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Strategies involving asset allocation and diversification do not ensure a profit or protect against a loss.

General risks inherent to investments in stocks include the fluctuation of market prices and dividend, loss of principal, market price at sell may be more or less than initial cost and potential illiquidity of the investment in a falling market

The Standard & Poor’s 500 Index is an unmanaged index generally representative of the U.S. Stock Market. It is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It is not possible to invest directly into this index.

 

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