The term “investment” has become muddled with overuse. A stock or a bond is an investment. People are now encouraged to make investments in their education, their cars, and even their flat-screen TVs. All of these things may make sound financial sense, but strictly speaking, they are not investments.
No matter what the commercials say, there are only three basic categories of investment: ownership, lending, and cash equivalents. They are products that are purchased with the expectation that they will produce income, or profit, or both.
- 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.
Defining The 3 Types Of Investments
1. Ownership Investments
Ownership investments 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 minuscule stake, but it’s ownership.
More broadly speaking, all traded securities, from futures to currency swaps, are ownership investments. Investors purchase them 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.
Your expectation of profit is realized (or not) by how the market values the asset that you own the rights to. If you own shares in Apple and the company posts a record profit, then 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.
There are two main ways to make money from stocks:
- Capital gains: When you buy shares in a company, the aim is for them to increase in value so that you can one day sell them for a profit. If, for example, you bought shares in Walmart at $120 apiece and then sold them five years later at $160 apiece, you would have made a $40 profit on each share. This profit is called a capital gain.
- Dividends: Companies often opt to share some of their profits with shareholders via a cash payment called a dividend. For each share you own, you’ll qualify to receive a certain amount of money. Some companies pay higher dividends than others. Usually, those that need to invest a lot to remain competitive and expand pay little to no dividends. Conversely, big and stable companies with plenty of excess cash are more likely to share their profits with investors. The frequency with which dividends are distributed varies. Some companies pay them quarterly, whereas others make these payments every month, once a year, or only on special occasions.
Investors generally love dividends, so paying them boosts share prices. However, there is always the risk that the company runs short of funds and is forced to cut or completely eliminate the dividend. When that happens, the share price usually falls.
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. 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 resell are investments.
The house that you live in can have multiple purposes. It fills a need for shelter. It may appreciate in value over time, but it may also lose value, depending on market conditions. In essence, the house that you live in not only provides basic necessities but also may be a source of income that can be realized when the house is sold at a profit.
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 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 view of the investor, they also have costs. They must be insured and kept in pristine condition to retain their value.
2. Lending Investments
Lending money is a category of investing. The risks generally are lower than for many investments; consequently, the rewards are relatively modest.
For example, 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 quite low, but the risk is essentially zero. In the United States, savings accounts are fully insured up to $250,000 by the Federal Deposit Insurance Corp. (FDIC).
A bond is a loan. When you purchase a bond, you are essentially lending money to the issuer, which could be a company or the government. And they will pay you back with interest, or coupons as they are called in the bond industry.
The primary risk is that the entity to which you are lending money goes bust and is no longer able to pay back what it owes. The greater the possibility this will happen, the lower it will usually be rated and the higher interest it will pay. Generally, the safest option is U.S. Treasuries, which are money lent to the U.S. government, followed by state and city government bonds, then bonds issued by companies.
Bonds also differ in terms of length, or maturity. Some of these loans will be short term, paying back the investor within little time, whereas others may last over a decade. Generally, the sooner money is due to be paid back, the lower the risk and the less the investor stands to earn.
In some cases, bonds may also be callable, meaning the loan can be paid back in advance before it is due to expire. Companies and governments may include this provision if they believe interest rates will fall in the future and borrowing will become cheaper.
Risks and returns vary widely among the different types of bonds. Generally, the higher the perceived risk of not making good on the loan, the more the entity must pay investors in the form of interest.
3. Cash Equivalents
These types of 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 a bank or credit union. 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. However, once you start writing checks on a money market account, you’ve erased much of its value as an investment.
These Are Not Investments
Education is often called an investment, and it certainly 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.
What are junk bonds?
Junk bonds are bonds deemed more likely to default, meaning that the company or government issuing it has a higher chance of not being able to pay back the money it is lent. Junk bonds are usually given low credit ratings, and buyers are compensated with higher interest rates. Entities in this position need to pay investors more because they represent a greater risk of default.
What are the safest investments?
Parking money in a savings account is pretty much risk free. U.S. bank accounts, including savings accounts, are fully insured up to $250,000 by the Federal Deposit Insurance Corp. (FDIC).
What are the riskiest investments?
Every investment is different, and it can be dangerous to categorize certain asset classes as safe or risky. For example, a lot of people say bonds are safer than stocks even though some fixed-income investments, such as junk bonds, may be riskier. Generally speaking, the riskiest investments are the speculative ones that offer potentially mammoth returns. That could be a startup, a cryptocurrency, or something else.
The Bottom Line
Investment is a word commonly used to describe the acquisition of pretty much anything that is assumed to save the owner money in some way, such as fuel-efficient cars and solar panels. In reality, anything that loses value shouldn’t be categorized as an investment. Instead, an investment is something that is purchased with the expectation that it will rise in value.
Investments can generally be broken down into three categories: ownership, lending, and cash equivalents. Ownership covers stakes in companies, setting up a business, real estate, and precious objects and collectibles. Lending, on the other hand, includes savings accounts and bonds. Cash equivalents include money market funds.