What is a hedge fund? A jargon-free guide

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If you’re confused about what a hedge fund is, you are not alone. Part of their allure is their exclusivity and secrecy. Hollywood only adds to that mystique in portraying hedge fund managers, such as the charming yet ruthless Bobby “Axe” Axelrod in the popular TV show Billions.

 

While hedge funds are considered unique investments in the world of personal finance, in simple terms, they are nothing more than an investment vehicle similar to a mutual fund. The difference is that the fund manager has broader discretion to invest in a wider variety of financial products other than just stocks and bonds.

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The popularity of hedge funds has exploded over the last few decades, and there are now almost $4 trillion invested in hedge funds worldwide.

What Is A Hedge Fund?

At its most basic, a hedge fund is a partnership between a professional fund manager and investors (often referred to as limited partners). The manager and investors pool money into a fund, using different strategies to grow the fund. If this sounds a lot like an actively managed mutual fund, you’re not wrong. The main difference between a mutual fund and a hedge fund is the amount of risk and diversity of products that a hedge fund can invest in versus a mutual fund.

 

Usually, a mutual fund is limited to investing in stocks and/or bonds. A hedge fund can invest in many other, often exotic, financial products. These can include real estate, derivatives, commodities, currency and more.

Hedge Fund Strategies

While there are hundreds of strategies employed by hedge funds to generate returns for their investors, most can be grouped into four main categories:

  • Global macro
  • Directional
  • Event-driven
  • Relative value

1. Global Macro Strategy

Hedge funds implementing a global macro strategy look at the big picture economic and political trends worldwide and attempt to capitalize on these large-scale ideas. Examples of this strategy would be looking at global trade imbalances, growth of emerging economies, business cycles, and supply and demand.

2. Directional Strategy

A directional strategy hedge fund uses market trends and directional market movements to identify equities or other securities. Often computer modeling is used to do technical trend analysis. One example of a directional strategy is a long/short equity hedge fund, which identifies opportunities in potentially undervalued stocks (long positions) and overvalued stocks (short positions). If the stocks move in the trending direction, the fund will make money.

3. Event-Driven Strategy

An event-driven hedge fund strategy seeks to identify risks and opportunities in specific events and make trades that pay off if those risks or opportunities are realized. For example, there could be trading opportunities around large corporate events such as mergers, consolidations, liquidations, or bankruptcies.

4. Relative Value (Arbitrage) Strategy

A relative value strategy will attempt to take advantage of price discrepancies between securities, otherwise known as arbitrage. Investopedia defines arbitrage as “the simultaneous purchase and sale of the same asset in different markets to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of similar financial instruments in different markets or different forms.”

 

A simple example of arbitrage is buying collectibles at a garage sale for a few dollars and then selling them on eBay for $50, $100, or more. In this case, you are taking advantage of a price mismatch for what you could pay for something versus its value in the broader market. Some people do this as a side hustle (or even full time), making $1,000 a month or more. In the same way, hedge funds take advantage of price mismatches in the market to generate profits.

How Can You Invest in Hedge Funds?

Investing in a hedge fund is not as simple as buying a stock. Due to government restrictions and minimum investment thresholds, the average person cannot invest directly in a hedge fund.

 

So who can invest in a hedge fund?

 

Because of their high-risk nature, the SEC (Securities and Exchange Commission) stipulates you must be an accredited investor (or in some cases a qualified purchaser) to put your money into a hedge fund.

 

An accredited investor must have a net worth of $1 million, not including the value of their primary home, or an annual income of $200,000 if single and $300,000 if married. A qualified purchaser designation is even more stringent. You must have at least $5 million in investable assets.

 

If you meet these requirements, you can research funds online or get the guidance of a financial advisor who may have more access to available hedge fund investments. Another thing to be aware of is that most hedge funds require a significant minimum investment, usually anywhere from $100,000 to $1,000,000+.

 

All of these hurdles and restrictions put most hedge funds out of the reach of the average investor. If you’re just getting started and wanting to learn how to invest $1,000, hedge funds are not the right product for you.

 

In many cases, high liquid net worth individuals invest in hedge funds to diversify their portfolios or mitigate a specific risk in their investments. For the average person, investing in broad-based index funds can be a better choice, as there are many risks to investing in hedge funds.

How Do Hedge Funds Make Money?

Hedge funds make money through their fee structure, as well as their underlying performance. A typical hedge fund fee structure is “2 and 20”, which means they charge a 2% annual fee on the total assets under management, as well as a performance fee of 20% of the total profit.

 

There is much criticism of this fee structure, as it is not entirely aligned with investors’ interests. The fund will collect its 2% cut, even in a down year where the fund broke even or lost money. Compared to the ultra-low fees of an index fund (0.1% or lower in many cases), the hedge fund manager must do significantly better than the overall market just to make up for their fees.

Benefits and Risks of Hedge Funds

Compared to investing index or mutual funds, hedge funds have some unique benefits and risks.

Benefits of Hedge Funds

  • Flexible Investment Strategies: Unlike mutual funds, hedge funds have more latitude to use strategies such as leverage, short selling, and derivatives to increase returns.
  • Reduced Losses in Market Downturns: Many hedge fund strategies attempt to be “market neutral” and provide a reasonably consistent return regardless of if the overall market is up or down.
  • Diversification: With the ability to implement many different strategies, allocating some of your portfolio to hedge funds effectively “hedges” your risk of relying on the overall market.

Risks of Hedge Funds

  • Fees: Compared to mutual funds and index funds, hedge funds have much higher fees, which requires their returns to be even higher just to break even.
  • Lack of Transparency: Hedge funds are not regulated with the same scrutiny as publicly traded funds, so it is hard to assess whether the manager is making good decisions or not.
  • Liquidity: Most hedge funds have lock-up periods from one to five years or more where you cannot take out your money, or if you can, there is a significant financial penalty.

Famous Hedge Fund Examples

Many prominent hedge fund managers attain celebrity status, at least within financial circles, and some have achieved household-name status, especially after the 2008 financial crisis. Here are some of the major hedge fund players today.

1. Blackrock Advisors

Blackrock was founded in 1984 and now has trillions of assets under management across many different hedge funds and even passively-managed index funds. Blackrock was made famous after the 2008 financial crisis by becoming one of the largest funds to accumulate single-family homes and earn a significant return on equity in real estate in the process.

2. AQR Capital Management

AQR Capital Management started in 1998 and has a significant focus on quantitative (computational) investing. Founded by Cliff Asness, David Kabiller, John Liew and Robert Krail, the firm has more than $140 billion in assets under management.

3. Bridgewater Associates

Ray Dalio founded Bridgewater Associates in 1975, and it has grown to around $140 billion in assets. Dalio is a particularly public figure and has written many articles and books on macroeconomic trends and investing.

4. Pershing Square Capital Management

Headed by billionaire investor Bill Ackman, Pershing Square was established in 2003. Ackman is best known as an activist investor, putting money into struggling companies and helping steer them in a more profitable direction.

Final Word

While hedge funds can be a powerful investing tool, they also come with unique risks. For the average person who doesn’t have millions to invest, the high fees and minimums can turn off. But hedge funds can be an excellent way for high net worth individuals to diversify their portfolio and accomplish what their name says: hedging against downturns in the market or other portfolio risks.

 

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50 investment phrases, decoded

 

Any new endeavor — from rock climbing to investing — means getting familiar with new words and phrases. Some investment terms may seem complex, but this list will take the mystery out of the most common investing terminology, so you can feel even more confident as you start your investing journey.

 

RelatedIs there such a thing as a safe investment?

 

 

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Alpha is used to gauge the success of an investment strategy, portfolio, portfolio manager, or trader compared with a relevant benchmark. You may also hear alpha defined as “excess return” in that it refers to returns that can be attributed to active management, over and above market returns.

 

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An asset is anything that holds value that can be converted to cash. Personal assets might include your home, a car or other valuables. Business assets might include machinery or patents. When it comes to investing, assets are typically the securities you invest in.

 

 

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An asset class is a group of investments with similar characteristics that is likely to perform differently in the market than another asset class. Types of asset classes include stocks, bonds, real estate, currencies and more. Given the same market conditions, stocks and bonds often move in opposite directions. Most financial advisers recommend you invest in multiple asset classes in order to have a well-diversified portfolio and minimize risk.

 

 

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An asset allocation fund is a diversified portfolio consisting of various asset classes. Most asset allocation funds have a mix of stocks, bonds and cash equivalents. These types of funds can be popular as some advisors stress the importance of having diverse portfolios to minimize potential losses.

 

 

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Beta refers to how risky or volatile a security or portfolio is compared with the market overall. Calculating the beta of the stocks in your portfolio can help you determine how your portfolio might respond to market volatility. You can also gauge the beta of a stock to help determine how much risk it might add to your portfolio.

 

 

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A bear market occurs when the market declines, typically when broad market indexes fall 20% or more in two months or less. Bear markets can accompany a recession, but not always. They often signal that investors feel pessimistic about their investments’ ability to make money and the market’s ability to rebound.

 

 

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A bull market is the opposite of a bear market, meaning prices are rising or are expected to rise for extended periods of time. Bull markets usually mean security prices are rising for months or even years at a time.

 

 

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Blue chip companies are generally thought to be well-established, financially sound, and therefore high-quality investments. Blue chip stocks are typically large companies, and many of them are household names. In some cases, blue chips may be more expensive to invest in since they can be considered relatively stable and likely to grow.

 

 

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When governments or corporations need to borrow money they issue bonds. Investors who buy the bonds are effectively loaning that entity cash, which will be repaid according to the terms of the bond (e.g. a 10-year bond with an interest rate of 3%). Bonds are often considered to be relatively stable, lower-risk investments compared with stocks.

 

 

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An investment broker, whether a person or a firm, acts as a middleman to help investors buy and sell securities. Brokers may be necessary because some securities exchanges only allow members of that exchange to make an investment order. A broker’s primary function is to help clients place trades, although many brokers also help clients with market research and investment planning.

 

 

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You’ve probably heard that you should aim to have a diversified portfolio. That means investing in a range of asset classes that are likely to behave differently under different market conditions, in order to mitigate risk. A portfolio of only stocks, for instance, could be more vulnerable to market volatility than a portfolio that also included bonds, real estate, commodities and so on.

 

 

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When a company shares their profits with investors, these are called dividends. Dividends are often paid in cash (although they can be paid in stocks). Some companies — e.g. many blue chip firms — pay dividends, but not all companies do. Ordinary dividends are taxed differently than qualified dividends, so you may want to consult a tax professional if you own dividend-paying stocks.

 

 

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Also called fractional share investing, dollar based investing is a way for investors to buy partial shares of stocks. Instead of buying shares of a company, you instead invest a dollar amount. Dollar based investing is a great way for smaller investors to buy into popular companies that they may otherwise be priced out of.

 

 

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EBITDA is a way to evaluate a company’s performance that is considered more precise than simply looking at net income. EBITDA stands for: earnings before interest, taxes, depreciation, and amortization. To calculate EBITDA, use the following formula: Net Income + Interest + Taxes + Depreciation + Amortization.

 

 

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EBIT is a simpler way to calculate a company’s profits than EBITDA, as it’s only one part of the EBITDA equation (literally!). It stands for “earnings before interest and taxes.” It’s calculated using this formula: Net Income + Interest + Taxes.

 

 

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EPS stands for earnings per share, which is a common way investors measure how well a stock is performing. EPS is calculated by finding a company’s quarterly or annual net income and dividing it by the company’s outstanding shares of stock. Increases in EPS can be a sign that the company’s profit performance is on the upswing, whereas a decrease can be a red flag for investors.

 

 

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Exchange-traded funds, or ETFs, are similar to mutual funds in that the fund’s portfolio can include dozens or even hundreds of different securities, and investors buy shares of the fund. Unlike mutual funds, ETF shares can be traded like stocks throughout the day (mutual fund shares are traded once a day). Most ETFs are considered lower-cost, passive investments because they track an index, although there are actively managed ETFs.

 

 

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An expense ratio is an annual fee investors pay to cover the operating costs of mutual funds, index funds, ETFs and other types of funds. Fees are typically deducted from your investments automatically (you don’t pay a separate charge), and they can reduce your returns over time so it’s wise to shop around for lower fees. Expense ratios are calculated using this formula: Total Funds Costs / Total Fund Assets Under Management.

 

 

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Free cash flow is the money a company has after it has paid its expenses. This number is important to investors because it can show them how likely it is that a company could have extra cash for dividends or share buybacks. A continuous decrease in free cash flow over a few years can also be a red flag to investors.

 

 

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Growth stocks are shares in a company that’s growing faster than its competitors, typically showing potential for higher revenue or sales. Growth stock companies may be considered leaders in their industry.

 

 

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Hedge funds are usually managed by an LLC or limited partnership that invests in securities and other assets using money from multiple investors. Hedge funds tend to be more risky and expensive than mutual funds or ETFs, which often makes them accessible to more wealthy investors.

 

 

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Index funds are a type of mutual fund that invest in securities that mirror a particular index, such as the S&P 500 Index or the MSCI World Index. Indexes track many different sectors, from smaller U.S. companies to big global companies to various kinds of bonds. Each index acts as a proxy for how that market sector is performing; the corresponding index funds reflect that performance.

 

 

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The interest rate is the amount a lender charges to borrow money — and it can also mean the amount your cash earns in a savings, money market or CD account. The baseline interest rate in the U.S. is set by the Federal Reserve. This rate in turn influences savings rates, mortgage rates, credit card rates and more. Generally, when the Federal Reserve lowers interest rates, the stock market tends to rise.

 

 

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A large-cap company has $10 billion or more in market capitalization. These companies are often considered industry leaders, and are relatively conservative, low-risk, and safe investments. A company’s stock may be considered large cap, mid cap or small cap.

 

 

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Market capitalization, or market cap, is the value of a company’s total outstanding shares. It’s often used to measure a company’s value and build a diversified portfolio. You can calculate market cap by multiplying the number of outstanding shares by the current price per share. Companies with lower market caps usually have more room to grow and usually are associated with newer companies, meaning they can also be riskier.

 

 

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Mid-cap companies are usually between $2 billion to $10 billion in market capitalization, putting them somewhere between small- and large-cap companies. Many mid-cap companies are in a growth phase, making them attractive to some investors who believe the company may grow into a large-cap over time, although this is not guaranteed to happen.

 

 

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Mega-cap companies are the largest companies you can invest in, with a market value of $1 trillion or more. Mega-cap stocks are typically industry leaders and household name brands, like Apple or Microsoft.

 

 

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Mutual funds may invest in stocks, bonds and other securities — or a combination of these (e.g. a blended fund). Mutual funds can also be industry-specific (such as a mutual fund consisting only of energy stocks, green bonds, or tech companies and so on).

 

 

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When talking about investing, net income usually refers to how much a company makes (or its total losses) after it has paid all its expenses. Net income is therefore usually calculated by subtracting a company’s expenses from its revenue. Investors may want to know a company’s net income because it can help determine how profitable the company is, although EBITDA (defined above) is another measure.

 

 

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Not all stocks are publicly traded. These “private” stocks, often called over-the-counter stocks, usually have to be traded through a broker. Companies may offer OTC stocks if they don’t meet the requirements to be traded publicly. Such companies are often startups or other small companies. So, while these companies may eventually grow to be able to trade publicly, investing in them also carries the risk that they may fold or even engage in fraudulent activity since the market is far less regulated than publicly traded markets are.

 

 

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Investors commonly use P/E or price-to-earnings ratios to gain insight into how profitable a company is compared to its stock price. In other words, price-to-earnings ratios can help investors decide if the price of a stock is worth it when compared to how much a company is making.

 

 

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Banks are likely to offer their best customers — those with the best credit histories and the lowest risk of defaulting — a prime interest rate for a loan. The prime interest rate is generally the lowest rate the bank will offer. A bank’s criteria for determining their prime interest rate may vary, but most banks consider the federal funds rate when setting any interest rate.

 

 

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Portfolio management simply refers to how you select and manage the investments in your portfolio. There are many different management styles, such as active or passive, growth or value. Additionally, you can elect to manage your own portfolio or hire an individual or group to manage it for you.

 

 

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A preferred stock means investors own shares in a company and get scheduled dividends, similar to how bond interest payments work. Preferred socks may not fluctuate in price like common stocks do, meaning they are often less volatile and risky.

 

 

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You probably know what profit and losses are, but do you know how to read a company’s P&L or profit & loss statement? It can help you determine a company’s bottom line, as it can show you how well a company is doing compared to its peers in the same industry. If you’ve never read one before, this article about profit & loss statements could give you some tips on what to look for.

 

 

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Companies that offer stocks, bonds and mutual funds to investors are required to file a prospectus with the Securities and Exchange Commission that provides details about the investment they are offering (e.g. the expense ratio, the constituents of a fund and more). Investors can use the prospectus to better understand a given security and how it might fit in their portfolio, or not.

 

 

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A recession is a period of economic contraction. The National Bureau of Economic Research (NBER)  defines a recession further as a decline in monthly employment, personal income, and industrial production. As an investor, a recession may indicate a drop in the value of your portfolio, although this may be temporary: When looking at the history of U.S. recessions, the stock market has typically rebounded after recessions.

 

 

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Real estate investment trusts (REITs) are a way that investors can further diversify their portfolios. Instead of having the responsibility of managing an investment property yourself, you can invest in REITs, which are generally large-scale real estate projects that investors can help fund in exchange for partial ownership. Most REITs are publicly traded and pay dividends to investors.

 

 

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When looking for a company’s net income statement, you may come across the term “retained earnings,” also sometimes called unappropriated profit, uncovered loss, member capital, earnings surplus, or accumulated earnings. In general, retained earnings is the amount of money a company keeps and potentially reinvests after it gives its investors a dividend payout.

 

As an investor, knowing whether a company had positive retained earnings can help you determine how much money it has to continue growing. If its retained earnings are negative, that could be a sign the company is in debt and may not be a good investment.

 

 

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Return on equity, sometimes called return on net worth, can help investors compare how well companies are managing their stockholders’ contributions. You can calculate it using this formula: Net income/Average shareholder equity. A higher return on equity can signal to investors that a company is managing its money efficiently.

 

 

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Return on investment (ROI) is just that: the return you get after making an investment in a stock, bond, mutual fund, and so forth. Investors generally hope for a positive ROI, meaning that their investment has made a profit. While a good ROI will vary depending on the type of investments you’re making, some investors look to the historic return of the stock market (about 7%) as a barometer.

 

 

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A small-cap company usually has a market cap of $250 million to $2 billion. Investors may be attracted to a small-cap company because they believe it has growth potential or may be undervalued.

 

 

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SPAC stands for special purpose acquisition company. SPACs are shell companies that list shares on an exchange to raise money so they can merge with a privately held company. Once the merger between the public SPAC and the private company is complete, that company is now in effect a public company — which is why a SPAC is sometimes called a backdoor IPO. Many companies may elect to use SPACs instead of traditional IPOs because they are often faster and less expensive.

 

 

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If you’ve made it this far, you probably know what a stock is. To review, a stock is a way to buy a piece of ownership into a company. You can buy and sell your stocks depending on whether you anticipate your stocks will decrease or increase in value.

 

 

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stock exchange is the place where you buy, sell, or trade stocks. Common U.S. stock exchanges are the New York Stock Exchange (NYSE) and the Nasdaq.

 

 

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A stop-loss order can help investors have more control over their stocks. When a stock reaches a certain price that you choose, your broker will sell, buy, or trade that stock. Having a stop-loss order can help you limit how much money you make or lose in the stock market.

 

 

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A target date fund is a type of mutual fund that includes a mix of asset classes to provide investors with a portfolio that adjusts over time to become more conservative as they age. Target date funds are often used to help investors plan their retirements. Target funds are typically constructed around various target retirement years (e.g. 2030, 2040, 2050) so investors can pick a date that corresponds with their hoped-for retirement.

 

 

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value stock is a stock that investors believe is undervalued and/or inexpensive compared to its past prices on the stock market or with its competitors. Investors may consider a stock’s price-to-earnings ratio to help them determine if something is a value stock.

 

 

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Venture capital is money a startup uses to grow its business. This money usually comes from private investors or venture capital firms. Investors may elect to invest venture capital into startups they believe have the potential to be profitable with time.

 

 

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Yield is another way of referring to the return of an investment over a set period of time, expressed as a percentage. You may hear the term in relation to bonds (e.g. high-yield bonds), but yield is more accurately a measure of the cash flow an investor gets on the amount they invested in a security during that time period, and is different from total return.

 

 

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Getting familiar with a few key investing words and phrases can go a long way in helping you gain confidence when you’re new to investing. Getting fluent with investing terminology is like any other pursuit — there’s a learning curve at first, but the terms will feel more natural as you move forward and start investing regularly.

 

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This article originally appeared on SoFi.comand was syndicated by MediaFeed.org.

 

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