As a financial advisor, one of my “unofficial duties” is acting as a sort of translator: Taking financial terms, jargon, or legalese that may be important but are often hard to understand or more confusing than they need to be and explaining them in plain English.
I must admit, though, that we financial advisors slip into our own sort of language, sometimes. Our profession uses terms and idioms that make perfect sense to us, because we use them on a daily basis…but that may seem strange to others. So, in this message, I thought it would be good to break down some of those terms that I am often asked about. You may hear financial professionals use these terms in conversation, on their websites, or even in the media.
Basis Points. The Fed cut interest rates by 25 basis points today. The 10-year treasury bond has lost 47 basis points so far this year. The annual expense ratio for this fund is 100 basis points.
These are just a few examples of where you might hear the term “basis points” in a sentence. But on what earth are they?
A basis point is one one-hundredth of a percentage point, or 0.01%. So, ten basis points equals 0.10%. Twenty-five equals 0.25%, or a one-quarter of a percent. And 100 basis points equal 1%.
Financial professionals often uses the term when talking about changes in interest rates, bond yields, or even compensation. The obvious question here is, “Why?” Why use some obscure term instead of actual percentage points? I promise, it’s not to sound overly technical or mysterious!
There are two main reasons to use the term. The first is to actually avoid confusion rather than create it. Let’s say someone told you that a 4% interest rate “went up by 1%.” The question immediately becomes, “is the interest rate now 4.04%...or 5%?” In other words, did the interest rate rise by 1% of 4%, or 1% above 4%? By saying “interest rates went up by 100 basis points,” it immediately becomes clear that the rate is now 5%.
The other reason is because it can sometimes be hard to wrap your head around decimals. When we talk about numbers 0.05%, or 0.27%, it might not immediately be apparent whether those numbers represent something significant or nearly meaningless if you don’t know the context. By saying “five basis points” or “twenty-seven basis points,” we are using larger, rounder numbers that can be much easier to grasp.
Hopefully, your understanding of this just went up by 10,000 basis points.
Risk Tolerance vs Risk Capacity. All investing, as you know, involves some risk. The possibility of loss or some other negative consequence can never be eliminated. Understanding how much risk you are willing and able to accept, however, is crucial to investing successfully.
Note those two words, willing and able. The former reflects your risk tolerance. How much risk you can mentally handle; how much volatility you can feel comfortable with emotionally. If you take on more risk than you can tolerate, it will often lead to making sudden, snap decisions down the road which can seriously alter the time it takes to reach your financial goals.
Your risk capacity measures something a bit more objective: How large of a loss you can technically afford without altering your lifestyle or giving up your goals. It’s important for a financial advisor to assess both tolerance and capacity, because the answers will dictate when, how, and how much you actually invest.
Fiduciary. To understand why this term matters, it’s important to understand the difference between a suitability standard and a fiduciary standard. Legally, most financial professionals are only expected to make recommendations that are considered “suitable” for their clients. In other words, it’s okay if a recommendation is primarily in the advisor’s best interest, not the client’s, so long as it can still technically be considered suitable for the client’s situation.
Under the fiduciary standard, however, advisors must put their clients’ interests before their own. Even if the advice an advisor gives is less good for the advisor, they must give it if that’s what is best for the clients they serve.
It’s important to note that, as of this writing, the fiduciary standard is not a legal requirement for most financial professionals, although there have been several attempts to make it one over the years. However, most still choose to act according to this standard, which is why you often see the term.
Holistic. What do you think of when you hear the word “finances?” Your income? Taxes? Investments? Or do you think of them all together? If so, good. That means you’re thinking holistically!
Holistic is a word you’ll often hear among financial professionals. That’s because your finances are more than just your income, your investments, or any one thing. It’s everything, all interconnected. And when you can get all these different areas working in sync, each will become stronger as a result. They’re like organs, all intended to work in concert to ensure your overall financial health. And that’s what holistic means, in a financial context: Every area of your money planned for and maintained in reference to each other, forming a single whole.
Wealth Management vs Asset Management vs Capital Management. You will sometimes see these terms on a financial professional’s website or business card. Generally speaking, each describes which areas of finance the professional chooses to focus on. “Wealth management” goes back to the holistic idea we just talked about: Services that cover a person’s entire financial life. Asset management focuses more on the investment side of things: Stocks, bonds, real estate, and more. Capital management often means the same thing, although it can also refer to managing an organization’s finances rather than an individual’s. (It’s worth noting that even if a financial professional’s business name says, “capital management,” for example, they may still offer total wealth management, too.)
Hopefully this makes the language of financial professionals a little less mysterious. Have a great month!
Antoine