The word investment has become muddled with overuse. A stock or a bond is an investment. People are now encouraged to make investments in their educations, their cars, and even their flat-screen TVs. All of these things may make sound financial sense, but they are not, strictly speaking, investments.
No matter what the commercials say, there are only three basic categories of investment. They are products that are purchased with the expectation that they will produce income or profit, or both.
Defining The 3 Types Of Investments
1. Ownership Investments
Ownership is what comes to mind for most people when the word investment is batted around. These are the most volatile and profitable class of investment. The following are examples.
Owning stock means owning a portion of a company. It may be a miniscule stake, but it's ownership.
More broadly speaking, all traded securities, from futures to currency swaps, are ownership investments. Investors purchase them in order to share in the profits, or because they will increase in value, or both.
Some of these investments, such as stocks, come with the right to a portion of the company's value. Others, such as futures contracts, come with the right to carry out a certain action that will benefit their owners.
- Stocks, real estate, and precious metals are all ownership investments. The buyer hopes that they will increase in value over time.
- Lending money is an investment. Bonds and even savings accounts are loans that earn interest over time for the investor.
- Cash equivalents like money market accounts are easy to liquidate when needed and repay investors with a modest amount of interest.
Your expectation of profit is realized (or not) by how the market values the asset you own the rights to. If you own shares in Apple (AAPL) and the company posts a record profit, other investors are going to want Apple shares too. Their demand for shares drives up the price, increasing your profit if you choose to sell the shares.
The money put into starting and running a business is an investment.
Entrepreneurship is one of the toughest investments to make because it requires more than just money. Consequently, it is an ownership investment with extremely large potential returns.
By creating a product or service and selling it to people who want it, entrepreneurs can make huge personal fortunes. Bill Gates, founder of Microsoft and one of the world's richest men, is a prime example.
Houses and apartments that are purchased to rent out or to resell are investments.
The house you live in is a different matter because it is filling a basic need. It fills a need for shelter. It may appreciate in value over time, but it shouldn't be purchased with the expectation of profit. The mortgage meltdown of 2008 and the underwater mortgages it produced are a good illustration of the danger of considering a primary residence as an investment.
Anything that declines in value with use is not an investment. It's an expense.
Many people made the error of purchasing homes that they could not afford on the assumption that those houses could soon be sold for much more.
Precious Objects and Collectibles
Gold and precious gemstones, Impressionist paintings and signed LeBron James jerseys, all can all be considered ownership investments, provided that these objects were bought with the intention of reselling them for a profit.
Like any investments, they may rise or fall in value over time. Tastes in art and collectibles change. Gold and gems have market values that fluctuate.
From the cold-eyed view of the investor, they also have costs. They must be insured and kept in pristine condition in order to retain their value.
2. Lending Investments
Lending money is a category of investing. The risks generally are lower than for many investments and, consequently, the rewards are relatively modest.
A bond issued by a company or a government will pay a set amount of interest over a set period of time. The only real risk is that the company or government will go bankrupt, in which case the bondholder may get little or none of the investment back.
A regular savings account is an investment. The investor is essentially lending money to the bank. The bank will pay interest to the account holder and will earn its profit by loaning out the rest of the money to businesses at a higher rate of interest.
The return on savings accounts is currently quite low, but the risk is essentially zero. In the U.S., savings accounts are fully insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC).
The risks and returns vary widely between the different types of bonds. Overall, these types of lending investments pose a lower risk and provide a lower return than ownership investments.
3. Cash Equivalents
These are investments are "as good as cash," which means that they can be converted back to cash easily and quickly.
Money Market Funds
Money market funds are similar to savings accounts and can be purchased at any bank. The difference is that the investor commits to leaving the money alone for a period of time in return for a slightly higher rate of interest. The time period is as little as three months and no longer than a year.
Money market funds are more liquid than other investments, meaning you can write checks out of money market accounts just as you would with a checking account. Although, once you start writing checks on it you've erased much of its value as an investment.
These Are Not Investments
Education is often called an investment and certainly, it can have lifelong rewards that include a higher income. It could be argued that we sell our education as if it was a small business service in exchange for a steady income.
By this logic, we're investing when we buy a stress ball or a cup of coffee. These are goods that offer benefits but they are not investments.
Beds, cars, mobile phones, TVs, and anything else that depreciates in value with use and time, are not investments. You may spend more to acquire something of higher intrinsic value but once you've used it it's still used goods.