What is Investing?

Investing is the act of allocating funds to an asset or committing capital to an endeavor (a business, project, real estate, etc.), with the expectation of generating an income or profit. In colloquial terms, investing can also mean putting in time or effort - not just money - into something with a long-term benefit, such as an education.

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Introduction To Value Investing

Understanding Investing

The expectation of a return in the form of income or price appreciation is the core premise of investing. The spectrum of assets in which one can invest and earn a return is a very wide one. Risk and return go hand-in-hand in investing; low risk generally means low expected returns, while higher returns are usually accompanied by higher risk. At the low-risk end of the spectrum are basic investments such as Certificates of Deposit; bonds or fixed-income instruments are higher up on the risk scale, while stocks or equities are regarded as riskier still, with commodities and derivatives generally considered to be among the riskiest investments. One can also invest in something as mundane as land or real estate, while those with a taste for the esoteric - and deep pockets - could invest in fine art and antiques.

Risk and return expectations can vary widely within the same asset class. For example, a blue chip that trades on the New York Stock Exchange will have a very different risk-return profile from a micro-cap that trades on a small exchange.

The returns generated by an asset depend on the type of asset. For instance, many stocks pay quarterly dividends, bonds generally pay interest every quarter, and real estate provides rental income. In many jurisdictions, different types of income are taxed at different rates.

In addition to regular income such as a dividend or interest, price appreciation is an important component of return. Total return from an investment can thus be regarded as the sum of income and capital appreciation. As of March 2019, Standard & Poor's estimates that since 1926, dividends have contributed nearly a third of total equity return while capital gains have contributed two-thirds.

Key Takeaways

  • In investing, risk and return are two sides of the same coin; low risk generally means low expected returns, while higher returns are usually accompanied by higher risk.
  • Risk and return expectations can vary widely within the same asset class; a blue-chip that trades on the NYSE and a micro-cap that trades over-the-counter will have very different risk-return profiles.
  • The type of returns generated depends on the asset; many stocks pay quarterly dividends, while bonds pay interest every quarter and real estate provides rental income.
  • Whether buying a security qualifies as investing or speculation depends on three factors - the amount of risk taken, the holding period, and the source of returns.

Types of Investments

While the universe of investments is a vast one, here are the most common types of investments:

Stocks - A buyer of a company's stock becomes a fractional owner of that company. Owners of a company's stock are known as its shareholders, and can participate in its growth and success through appreciation in the stock price and regular dividends paid out of the company's profits.

Bonds - Bonds are debt obligations of entities such as governments, municipalities and corporations. Buying a bond implies that you hold a share of an entity's debt, and are entitled to receive periodic interest payments and the return of the bond's face value when it matures.

Funds - Funds are pooled instruments managed by investment managers that enable investors to invest in stocks, bonds, preferred shares, commodities etc. The two most common types of funds are mutual funds and exchange-traded funds or ETFs. Mutual funds do not trade on an exchange and are valued at the end of the trading day; ETFs trade on stock exchanges and like stocks, are valued constantly throughout the trading day. Mutual funds and ETFs can either passively track indices such as the S&P 500 or the Dow Jones Industrial Average, or can be actively managed by fund managers.

Investment trusts: Trusts are another type of pooled investment, with Real Estate Investment Trusts (REITs) the most popular in this category. REITs invest in commercial or residential properties and pay regular distributions to their investors from the rental income received from these properties. REITs trade on stock exchanges and thus offer their investors the advantage of instant liquidity.

Alternative Investments - This is a catch-all category that includes hedge funds and private equity. Hedge funds are so called because they can hedge their investment bets by going long and short stocks and other investments. Private equity enables companies to raise capital without going public. Hedge funds and private equity were typically only available to affluent investors deemed "accredited investors" who met certain income and net worth requirements. However, in recent years, alternative investments have been introduced in fund formats that are accessible to retail investors.

Options and Derivatives - Derivatives are financial instruments that derive their value from another instrument such as a stock or index. An option is a popular derivative that gives the buyer the right but not the obligation to buy or sell a security at a fixed price within a specific time period. Derivatives usually employ leverage, making them a high-risk, high-reward proposition.

Commodities - Commodities include metals, oil, grain and animal products, as well as financial instruments and currencies. They can either be traded through commodity futures - which are agreements to buy or sell a specific quantity of a commodity at a specified price on a particular future date - or ETFs. Commodities can be used for hedging risk or for speculative purposes.

Comparing Investing Styles

Let's compare a couple of the most common investing styles:

Active versus Passive Investing - The goal of active investing is to "beat the index" by actively managing the investment portfolio. Passive investing, on the other hand, advocates a passive approach such as buying an index fund, in tacit recognition of the fact that it is difficult to beat the market consistently. While there are props and cons to both approaches, in reality, few fund managers beat their benchmarks consistently enough to justify the higher costs of active management.

Growth versus Value - Growth investors prefer to invest in high-growth companies, which typically have higher valuation ratios such as Price-Earnings (P/E) than value companies. Value companies have significantly lower PE's and higher dividend yields than growth companies because they may be out of favor with investors, either temporarily or for a prolonged period of time.

How to Invest

The question of "how to invest" boils down to whether you are a Do-It-Yourself (DIY) kind of investor or would prefer to have your money managed by a professional. Many investors who prefer to manage their money themselves have accounts at discount brokerages because of their low commissions and the ease of executing trades on their platforms. Investors who prefer professional money management generally have wealth managers looking after their investments. Wealth managers usually charge their clients a percentage of assets under management (AUM) as their fees. While professional money management is more expensive than managing money by oneself, such investors don't mind paying for the convenience of delegating the research, investment decision-making and trading to an expert.

Brief History of Investing

While the concept of investing has been around for millennia, investing in its present form traces its roots back to the period between the 17th and 18th centuries, when the development of the first public markets connected investors with investment opportunities. The Amsterdam Stock Exchange was established in 1787, followed by the New York Stock Exchange (NYSE) in 1792. The Industrial Revolutions of 1760-1840 and 1860-1914 resulted in greater prosperity as a result of which people amassed savings that could be invested, fostering the development of an advanced banking system. Most of the established banks that dominate the investing world began in the 1800s, including Goldman Sachs and J.P. Morgan. The 20th century saw new ground being broken in investment theory, with the development of new concepts in asset pricing, portfolio theory and risk management. In the second half of the 20th century, many new investment vehicles were introduced, including hedge funds, private equity, venture capital, REITs and ETFs.

In the 1990s, the rapid spread of the Internet made online trading and research capabilities accessible to the general public, completing the democratization of investing that had commenced more than a century ago.

Investing versus Speculation

Whether buying a security qualifies as investing or speculation depends on three factors:

  • The amount of risk taken on - Investing usually involves a lower amount of risk compared with speculation.
  • The holding period of the investment - Investing typically involves a longer holding period, measured quite frequently in years; speculation involves much shorter holding periods.
  • Source of returns: Price appreciation may be a relatively less important part of returns from investing, while dividends or distributions may be a major part. In speculation, price appreciation is generally the main source of returns.

As price volatility is a common measure of risk, it stands to reason that a staid blue-chip is much less risky than a cryptocurrency. Thus, buying a dividend-paying blue chip with the expectation of holding it for a number of years would qualify as investing. On the other hand, a trader who buys a cryptocurrency with the intention of flipping it for a quick profit in a couple of days is clearly speculating.

In March 2019, Norway's $1-trillion sovereign wealth fund announced that it would gradually phase out its investments in oil exploration and production companies, evidence of the growing popularity of Socially Responsible Investing (SRI).

Example of Return from Investing

Assume you purchased 100 shares of a stock for $50 and sold it exactly a year later for $60. Over the one-year holding period, you received $2.50 in dividends per share. What was your approximate total return, ignoring commissions?

Capital gain = ($60 - $50) = ($10/$50) x 100% = 20%

Dividends = (250 / $5000) x 100% = 5%

Total return = 25%