What Is an Investment?
An investment is an asset or item acquired with the goal of generating income or appreciation. Appreciation refers to an increase in the value of an asset over time. When an individual purchases a good as an investment, the intent is not to consume the good but rather to use it in the future to create wealth.
An investment always concerns the outlay of some resource today—time, effort, money, or an asset—in hopes of a greater payoff in the future than what was originally put in. For example, an investor may purchase a monetary asset now with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit.
- An investment involves putting capital to use today in order to increase its value over time.
- An investment requires putting capital to work, in the form of time, money, effort, etc., in hopes of a greater payoff in the future than what was originally put in.
- An investment can refer to any medium or mechanism used for generating future income, including bonds, stocks, real estate property, or alternative investments.
- Investments usually do not come with guarantees of appreciation; it is possible to end up with less money than with what you started.
- Investments can be diversified to reduce risk, though this may reduce the amount of earning potential.
What's an Investment?
How an Investment Works
The act of investing has the goal of generating income and increasing value over time. An investment can refer to any mechanism used for generating future income. This includes the purchase of bonds, stocks, or real estate property, among other examples. Additionally, purchasing a property that can be used to produce goods can be considered an investment.
In general, any action that is taken in the hopes of raising future revenue can also be considered an investment. For example, when choosing to pursue additional education, the goal is often to increase knowledge and improve skills. The upfront investment of time attending class and money to pay for tuition will hopefully result in increased earnings over the student's career.
Because investing is oriented toward the potential for future growth or income, there is always a certain level of risk associated with an investment. An investment may not generate any income, or may actually lose value over time. For example, a company you invest in may go bankrupt. Alternatively, the degree you investing time and money to obtain may not result in a strong job market in that field.
An investment bank provides a variety of services to individuals and businesses, including many services that are designed to assist individuals and businesses in the process of increasing their wealth. Investment banking may also refer to a specific division of banking related to the creation of capital for other companies, governments, and other entities. Investment banks underwrite new debt and equity securities for all types of corporations, aid in the sale of securities, and help to facilitate mergers and acquisitions.
Types of Investments
There's arguably endless opportunities to invest; after all, upgrading the tires on your vehicle could be seen as an investment that enhances the usefulness and future value of the asset. Below are common types of investments in which people use to appreciate their capital.
A share of stock is a piece of ownership of a public or private company. By owning stock, the investor may be entitled to dividend distributions generated from the net profit of the company. As the company becomes more successful and other investors seek to buy that company's stock, it's value can also appreciate and be sold for capital gains.
The two primary types of stocks to invest in are common stock and preferred stock. Common stock often includes voting right and participation eligibility in certain matters. Preferred stock often have first claim to dividends and must be paid before common shareholders.
In addition, stocks are often classified as being either growth or value investments. Investments in growth stocks is the strategy of investing in a company while it is small and before it achieves market success. Investment in value stocks is the strategy of investing in a more established company whose stock price may not appropriate value the company.
A bond is an investment that often demands an upfront investment, then pays a reoccurring amount over the life of the bond. Then, when the bond matures, the investor receives the capital invested into the bond back. Similar to debt, bond investments are a mechanism for certain entities to raise money. Many government entities and companies issue bonds; then, investors can contribute capital to earn a yield.
The recurring payment awarded to bondholders is called a coupon payment. Because the coupon payment on a bond investment is usually fixed, the price of a bond will often fluctuate to change the bond's yield. For example, a bond paying 5% will become cheaper to buy if there are market opportunities to earn 6%; by falling in price, the bond will naturally earn a higher yield.
Many investments can be leveraged for higher returns (or higher losses) through derivative products. It's often recommended that investors not handle derivatives unless they are aware of the high risk involved.
Index Funds and Mutual Funds
Instead of selecting each individual company to invest in, index funds, mutual funds, and other types of funds often aggregate specific investments to craft one investment vehicle. For example, an investor can buy shares of a single mutual fund that holds ownership of small cap, emerging market companies instead of having to research and select each company on its own.
Mutual funds are actively managed by a firm, while index funds are often passively-managed. This means that the investment professionals overseeing the mutual fund is trying to beat a specific benchmark, while index funds often attempt to simply copy or imitate a benchmark. For this reason, mutual funds may be a more expense fund to invest in compared to more passive-style funds.
Real estate investments are often broadly defined as investments in physical, tangible spaces that can be utilized. Land can be built on, office buildings can be occupied, warehouses can store inventory, and residential properties can house families. Real estate investments may encompass acquiring sites, developing sites for specific uses, or purchasing ready-to-occupy operating sites.
In some contexts, real estate may broadly encompass certain types of investments that may yield commodities. For example, an investor can invest in farmland; in addition to reaping the reward of land value appreciation, the investment earns a return based on the crop yield and operating income.
Commodities are often raw materials such as agriculture, energy, or metals. Investors can choose to invest in actual tangible commodities (i.e. owning a bar of gold) or can choose alternative investment products that represent digital ownership (i.e. a gold ETF).
Commodities can be an investment because they are often used as inputs to society. Consider oil, gas, or other forms of energy. During periods of economic growth, companies often have greater energy needs to ship more products or manufacture additional goods. In addition, consumers may have greater demand for energy due to travel. In this example, the price of commodities fluctuates and may yield a profit for an investor.
Cryptocurrency is a blockchain-based currency used to transact or hold digital value. Cryptocurrency companies can issue coins or tokens that may appreciate in value. These tokens can be used to transact with or pay fees to transact using specific networks.
In addition to capital appreciation, cryptocurrency can be staked on a blockchain. This means that when investors agree to lock their tokens on a network to help validate transactions, these investors will be rewarded with additional tokens. In addition, cryptocurrency has given rise to decentralized finance, a digital branch of finance that enables users to loan, leverage, or alternatively utilize currency.
A less traditional form of investing, collecting or purchasing collectibles involves acquiring rare items in anticipation of those items becoming in higher demand. Ranging from sports memorabilia to comic books, these physical items often require substantial physical preservation especially considering that older items usually carry higher value.
The concept behind collectibles is no different than other forms of investing such as equities. Both predict that the popularity of something will increase in the future. For example, a current artist may not be popular but changes in global trends, styles, and market interest. However, their art may become more valuable in time should the general population take a stronger interest in their work.
An investment (i.e. stocks or bonds) is overseen at a financial institution (i.e. a broker). In addition, there are different vehicles (i.e an IRA) that hold the investments. As you start investing, you'll need to figure out what you want for both.
How to Start Investing
There are many different avenues one can take when learning how to invest or where to start when putting money aside. Here are some tips for getting started in investing:
- Do your own research. A common phrase used in the investing industry, it is important for investors to understand the vehicles they are putting their money into. Whether it is a single share of a well-established company or a risky alternative investment endeavor, investors should do their homework in advance as opposed to relying on third-party (and often biased) advice.
- Establish a personal spending plan. Before investing, individuals should consider their ability to put money away. This includes ensuring they have enough capital to pay monthly expenses and have already built up an emergency fund. As enticing as investing can be, individuals should be mindful to meet their daily life obligations first.
- Understand liquidity restrictions. Some investors may be less liquid than others, meaning it may be more difficult to sell. In some cases, an investment may be locked for a certain period and cannot be liquidated. Though not necessary fine print, it's important to understand whether certain investments can be bought or sold at any time.
- Research tax implications. On a similar note, though an investment can be bought or sold at any time, it may be tax-adverse to do so. With unfavorable short-term capital gains tax rates, investors should be mindful of strategies that extend beyond what product they hold but what tax vehicle they put that investment in.
- Gauge your risk preference. As mentioned earlier, investing incurs risk. This means you may end up with less money than what you started with. Investors uncomfortable with this idea can (1) reduce the amount they invest to only what they are comfortable losing or (2) explore ways to mitigate risk.
- Consult an adviser. Many financial professionals would be happy to provide their guidance, let you know what they think about markets, and give you access to online platforms where you can invest money.
Return on Investment
The primary way to gauge the success of an investment is to calculate the return on investment (ROI). ROI is measured as:
ROI = (Current Value of Investment - Original Value of Investment) / Original Value of Investment
ROI allows different investments across different industries to be appropriately compared. For example, consider two investments: a $1,000 investment in stock that increased to $1,100 over the past year, or a $150,000 investment in real estate that is now worth $160,000.
Stock ROI = ($1,100 - $1,000) / $1,000 = $100 / $1,000 = 10%
Real Estate ROI = ($160,000 - $150,000) / $150,000 = $10,000 / $150,000 = 6.67%
Though the real estate investment has increased in value $10,000, many would claim that the stock investment has outperformed the real estate investment. This is because every dollar invested in the stock gained more money than every dollar invested in real estate.
ROI isn't everything; consider an investment that earns a stead 10% ROI each year compared to a second investment that has an equal chance of earning 25% or losing 25%. For some, stable earnings outpace higher earning investment potential.
Investments and Risk
In its simplest form, investment return and risk should have a positive correlation. If an investment carries high risk, it should be accompanied by higher returns. If an investment is safer, it will often have lower returns.
When making investment decisions, investors must gauge their risk appetite. Every investor will be different, as some may be willing to risk the loss of principle in exchange for the chance at greater profits. Alternatively, extremely risk-averse investors seek only the safest vehicles where their investment will only consistently (but slowly) grow.
Investments and risk are often strongly related to prevailing conditions in the investor's life. As an investor approaches retirement, they will no longer have stable, ongoing income. For this reason, people usually choose safer investments towards the end of their working career. On the other hand, a young professional can often bear the burden of losing money as they have their entire career to make that capital back. For this reason, younger investors are often more likely to invest in riskier investments.
Investments and Diversification
One way investors can reduce portfolio risk is to have a broad range of what they are invested in. By holding different products or securities, an investor may not lose as much money as they are not fully exposed in any one way.
The concept of diversification was born from modern portfolio theory, the idea that holding both equities and bonds will positively impact the risk-adjusted rate of return in a portfolio. The argument is holding strictly equities may maximize returns but also maximizes volatility. Pairing it with a more stable investment with lower returns will decrease the risk an investor incurs.
Investing vs. Speculation
Speculation is a distinct activity from investing. Investing involves the purchase of assets with the intent of holding them for the long term, while speculation involves attempting to capitalize on market inefficiencies for short-term profit. Ownership is generally not a goal of speculators, while investors often look to build the number of assets in their portfolios over time.
Although speculators are often making informed decisions, speculation cannot usually be categorized as traditional investing. Speculation is generally considered a higher risk activity than traditional investing (although this can vary depending on the type of investment involved). Some experts compare speculation to gambling, but the veracity of this analogy may be a matter of personal opinion.
Investing vs. Saving
Saving is accumulating money for future use and entails no risk, whereas investment is the act of leveraging money for a potential future gain and it entails some risk. Though both have the intention of having more capital available in the future, each go about growing in a very different way.
One aspect this is most transparent is the process of saving for a down payment on a home. Many advisors will suggest parking cash in a safer investment vehicle when saving for an important major purchase. Because investing incurs a higher degree of risk, an individual must compare what implications of loss of principle would be to their future plans.
Saving and investing are often intertwined because each may have a stated yield or rate of return. Another primary difference is the federal insurance coverage on certain accounts. The FDIC offers insurance coverage for bank accounts balances up to $250,000; this type of financial guarantee is often not present in investing.
How Is an Investment Different From a Bet or Gamble?
In an investment, you are providing some individual or entity with funds to be put to work growing a business, starting new projects, or maintaining day-to-day revenue generation. Investments, while they can be risky, have a positive expected return. Gambles, on the other hand, are based on chance and not putting money to work. Gambles are highly risky and also have a negative expected return in most cases (e.g., at a casino).
Is Investment the Same As Speculation?
Not really. An investment is typically a long-term commitment, where the payoff from putting that money to work can take several years. Investments are typically made only after due diligence and proper analysis have been undertaken to understand the risks and benefits that could unfold. Speculation, on the other hand, is a pure directional bet on the price of something, and often for the short-term.
What Are Some Types of Investments I Can Make?
Most ordinary individuals can easily make investments in stocks, bonds, and CDs. With stocks, you are investing in the equity of a company, which means you invest in some residual claim to a company's future profit flows and often gain voting rights (based on the number of shares owned) to give your voice to the direction of the company. Bonds and CDs are debt investments, where the borrower puts that money to use in a pursuit that is expected to bring in cash flows greater than the interest owed to the investors.
Why Invest When You Can Save Money With Zero Risk?
As mentioned, investing is putting money to work in order to grow it. When you invest in stocks or bonds, you are putting that capital to work under the supervision of a firm and its management team. Although there is some risk, that risk is rewarded with a positive expected return in the form of capital gains and/or dividend & interest flows. Cash, on the other hand, will not grow, and may very well lose buying power over time due to inflation. Put simply, without investment, companies would not be able to raise the capital needed to grow the economy.
The Bottom Line
An investment is a plan to put money to work today in hopes of obtaining a greater amount of money in the future. Though that plan may not always work out and investments can lose money, it is also the primary way people save for major purchases or retirement. Ranging from stocks, bonds, real estate, commodities, and modern alternative investments, the digital age has brought about easy, transparent, and fast methods of investing money.