Puzzled by investing jargon?

We clear up terms such as margin of safety, risk-free rate of return and sensitive stocks.

Adam Zoll 13 April, 2015 | 5:00PM

Earlier this year we began asking readers which investment terms are most puzzling to them. The goal was to identify jargon found on financial sites (including Morningstar.ca) or in financial statements and shareholder letters that many people just don't understand or don't understand well. Judging by the response, the financial-services industry has quite a ways to go when it comes to communicating with individual investors. Readers have submitted scores of terms for us to define -- from those covering the most basic investing concepts to others that are more abstract.

You can find our first batch of jargon definitions here and the second batch here. In the months since those articles ran, we've received additional submissions from confused readers asking us to clear up some of the fog. So, as an ongoing public service, let's tackle some more. 

Bid-ask spread: The difference between a security's ask price and its bid price. A tighter spread is likely to lead to more trading while a wider spread is likely to produce less.

Commodity: A raw, tangible good such as gold, silver, oil, natural gas, wheat or corn. Investors typically use futures contracts to gain exposure to commodity price movements. Commodities are regarded as a hedge against inflation and a portfolio diversifier.

Dovish (central bank policy): Favouring growth-oriented policies, including lower interest rates, asset purchases, and other actions aimed at stimulating the economy. Also see "hawkish."

Growth/value: Morningstar defines growth stocks as those with the potential for better-than-average, long-term earnings growth and value stocks as those with low prices relative to their expected future earnings. A value stock typically will have a much lower price/earnings ratio than a growth stock. For more on how Morningstar assigns growth and value labels to stocks, see Morningstar's Style Box Methodology.

Hawkish: The opposite "dovish," favouring higher rates in order to combat the threat of inflation and opposing more stimulative measures.

Headwind/tailwind: Used to imply that a force is favourable (tailwind) or unfavourable (headwind) for a company or an investment. For example, high energy prices might act as a headwind for a manufacturing company because they will increase the firm's production costs.

Liquidity: The ease with which an asset can be converted to cash. For example, some small-company stocks are thinly traded and thus lack the liquidity of more heavily traded stocks.

Margin of safety: A margin of error, or cushion, that some investors use to make sure they are buying a security at a good price--one at which they may still make a profit even if their thesis proves incorrect. The greater the uncertainty about a stock, the greater the required margin of safety. For example, a value investor might require that a stock trade well below his estimate of its fair market value before buying it. This minimum gap between the stock's fair market value and the investor's acceptable purchase price is the margin of safety.

Multiple (and multiple expansion): Shorthand for the relationship between a stock's price and a company's earnings, or its P/E ratio. For example, a stock trading for $10 per share with company earnings of $1 per share has a P/E ratio of 10 and has a lower multiple than a stock with a P/E ratio of 20. Multiple expansion refers to a growing P/E ratio, which is to say investors are willing to pay more for each dollar of company earnings. Thus, the P/E ratio grows. This could mean that the stock may be becoming overpriced or that the market believes the company's earnings will grow faster in the future than previously expected.

Risk-free rate of return: The rate of return investors could have gotten by owning the safest available investment, such as short-term Government of Canada T-bills. Morningstar uses the difference between a fund's performance and the risk-free rate of return in calculating metrics such as the Morningstar Rating for funds (or star rating), the Morningstar Return rating, and the Morningstar Risk rating.

ROE (Return on Equity): A measure of how profitable a company is relative to the amount of money shareholders have invested in the firm. It's a key metric investors use to gauge a firm's profitability.

Sensitive stocks: Morningstar classifies some stocks as part of a sensitive supersector, meaning that they are more affected by the ebb and flow of the economy than defensive stocks are, but not as much as cyclical stocks are. The sensitive supersector includes communications services, energy, industrials and technology stocks.

Short ratio: The number of short positions in a stock divided by its average daily trading volume. A high short ratio suggests that investors expect the stock's price to go down.

Soft landing: In economic terms, a desirable outcome following a period of strong growth, and one that avoids a sharp downturn or crash. This aviation term is often used in reference to Fed policy. For example, "Once the central bank begins raising rates again, it will need to do so carefully to ensure a soft landing."

In addition to these terms, we've explained others in previous Ask the Expert columns, including ADR, contango, derivatives, floating-rate fund, maturity/duration, Monte Carlo simulation, NAV , smart (or strategic) beta, strategic/tactical investing and yield curve. We also broke down many of the terms found on company earnings statements.

Are there additional investing terms that you've wondered about and that aren't included here? Email them to us for possible use in a future article.

Have a personal finance question you'd like answered? Send it to AskTheExpert@morningstar.com.

About Author

Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com