What is investment?
Investment, broadly speaking, is putting money to work in some kind of project or activity for a period of time to generate a positive return.
It is the act of allocating resources, usually capital (i.e. money), with the expectation of generating income, profit or gain.
A person can invest in many types of endeavors.
Such as using the money to start a business, or buying real estate with the hope of generating rental income and/or reselling at a higher price later.
Investments differ from savings in that the money used is put to work, which means that there is some implicit risk that the associated projects may fail, resulting in a loss of money.
Investing also differs from betting because in the latter case, money is not put to work per se, but speculation is made on short-term price fluctuations.
Investment means increasing money over time.
The mainstay of investing is the expectation of positive returns in the form of income or price appreciation with statistical significance.
The spectrum of assets in which one can invest and earn returns is very wide.
Risk and return go hand in hand in investing; Lower risk usually means lower expected return, while higher return is usually accompanied by higher risk.
At the low-risk end of the spectrum are basic investments such as certificates of deposit (CDs); Bonds or fixed income instruments are higher on the risk scale, while stocks or equities are considered risky.
Commodities and derivatives are generally considered among the riskiest investments. One can also invest in fragile items like land or real estate or 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 than a micro-cap that trades on a smaller exchange.
The return earned by an asset depends on the type of asset.
For example, many stocks pay quarterly dividends, while bonds generally pay interest quarterly.
In many jurisdictions, different types of income are taxed at different rates.
Apart from regular income, such as dividends or interest, price appreciation is an important component of returns.
Thus the total return on investment can be calculated as the sum of income and capital appreciation.
Standard & Poor’s estimates that since 1926, dividends have contributed nearly one-third of total equity returns while capital gains have contributed two-thirds.
So capital gains are an important part of investing.
Types of investment
Today, investment is mostly associated with financial instruments that allow individuals or businesses to raise capital and deploy companies.
These companies then raise that capital and use it for growth or profit-generating activities.
Although the universe of investments is vast, here are the most common types of investments:
A buyer of a company’s stock becomes a fractional owner of that company.
Owners of a company’s shares are known as its shareholders and can participate in its growth and success by paying regular dividends from stock price appreciation and company profits.
Bonds are debt obligations of organizations such as governments, municipalities, and corporations.
Buying bonds implies that you own a share of an institution’s debt and are entitled to receive periodic interest payments and a return of the bond’s face value when it matures.
Funds are collective 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 have their value at the end of the trading day.
ETFs are traded on stock exchanges and, like stocks, are valued continuously throughout the trading day.
Mutual funds and ETFs can either passively track indexes, such as the S&P 500 or the Dow Jones Industrial Average, or be actively managed by fund managers.
Trusts are another type of pooled investment, with real estate investment trusts (REITs) being the most popular of these categories.
REITs invest in commercial or residential properties and make regular distributions to their investors from the rental income derived from these properties.
REITs trade on stock exchanges and thus provide their investors with the benefit of immediate liquidity.
Alternative investments are 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 on stocks and other investments. Private equity enables companies to raise capital without going public. Hedge funds and private equity were generally only available to wealthy investors considered “accredited investors” who met certain income and net worth requirements. However, in recent years, alternative investments have been launched in fund formats available to retail investors.
Options and other derivatives
Derivatives are financial instruments that derive their value from another instrument, such as a stock or index.
Options contracts are popular derivatives that give the buyer the right but not the obligation to buy or sell a security at a specified price within a specified period of time.
Derivatives often involve leverage, making them a high-risk, high-reward proposition.
Commodities include metals, oil, grains and animal products as well as financial instruments and currencies. They can be traded either through commodity futures — which are contracts to buy or sell a specific amount of a commodity at a specific price at a specific future date — or ETFs. Commodities can be used for hedging risk or for speculative purposes.
Comparing investment styles
Let’s compare some of the most common investment styles:
Active vs. Passive Investing: Active investing aims to “beat the index” by actively managing an investment portfolio.
Passive investing, on the other hand, advocates a passive approach such as buying index funds, clearly recognizing the fact that it is difficult to consistently beat the market.
While there are pros and cons to both approaches, in reality, few fund managers consistently beat their benchmarks to justify the higher costs of active management.
Growth vs. Value: Growth investors prefer to invest in high-growth companies, which have higher value-earnings ratios such as price-earnings (P/E).
Value investors look for companies that have a significantly lower PE and higher dividend yields than growth companies because they may be favored by investors temporarily or over the long term.
How to invest
The “how to invest” question is whether you are a do-it-yourself (DIY) type of investor or prefer to have your money managed by a professional.
Many investors who prefer to manage their money themselves have accounts with discount or online brokerages because of the low commissions and ease of transacting on their platforms.
DIY investing is sometimes called self-directed investing and requires a fair amount of education, skill, time commitment and the ability to control one’s emotions.
If these attributes don’t describe you well, it may be smarter to get professional help managing your investments.
Investors who prefer professional money management usually have wealth managers look after their investments.
Wealth managers usually charge their clients a percentage of their assets under management (AUM) as fees.
Although professional money management is more expensive than managing money on your own, such investors do not mind paying for the convenience of delegating research, investment decisions and trading to an expert.
Some investors opt to invest based on suggestions from automated financial advisors.
Powered by algorithms and artificial intelligence, roboadvisors gather critical information about investors and their risk profiles to make appropriate recommendations.
Without any human investment intervention, roboadvisors offer a cost-effective way to invest with services similar to those offered by human investment advisors.
Thanks to advances in technology, robo-advisors are more than capable of picking investments. They can help people develop retirement plans and manage trusts and other retirement accounts, such as 401(k)s.