INVESTMENT FUNDAMENTALS
Investment characteristics /
Rewards / Risks / Types of investments
Investment characteristics
The idea of investment is simple: take something of value and put it to work in some way to increase its value over time. With any investment, one wants the original investment to grow, without losing it. This idea is called conservation of capital. Unfortunately, no investment is truly secure. External conditions change, and the investment itself can change. Even if you do nothing with it, its value does not remain constant.
Risk versus return. The general rule in investments is that the safer the investment, the more slowly it gains in value. The more you want it to gain, and the more quickly, the more you must risk losing it. How much do you want to earn, and how much are you willing to risk to earn it? Reward in investing corresponds directly to the degree of risk.
Management. Another aspect of investment is the amount of attention you must pay to it to make it work. You can deposit cash in a passbook account and forget about it. You can use your cash to buy a business and then run the business yourself to make your asset grow and earn. How much do you want to be involved in managing your investment?
Liquidity. The issue of exchangeability is an important one in investment. How easy is it to recover your invested resource, without loss, and exchange it for another one that you want? If there is a market for the type of resource you have- other people want to buy and sell it for themselves– your investment is liquid.
Rewards
The basic aim of financial investment is to increase one’s wealth, to add value to what you have. This can occur in several ways.
Income. An investment can generate income in some way on a periodic basis. You may consume this cash, spending it for goods and services that, when used up, have no further value. Or, you may use the cash to put into another investment.
Appreciation. Your invested asset itself may gain value over time because of an increase in market demand for it. When you sell or exchange it for something else you prefer to have, you get more than you originally put into the investment.
Leverage. You may pledge the value of your resource to borrow funds in order to make an investment that is larger than your own resource permits you to do directly. The small resource is used as a lever to make a larger investment, and thus increases your opportunity to benefit from income, appreciation, and the other rewards of investment.
Tax benefits. Some investments receive treatment under tax laws that enables the investor to reduce or defer the amount of tax owed. Tax dollars you don’t have to pay are dollars you have available for some other use, such as consuming or further investing.
Risks
Investment risks come from a variety of general sources, including the market, business operations, the value of money, and changes in the interest rate.
Market risk. Changes in the demand for your invested resource may cause your investment to lose value and to become illiquid.
Business risk. Changes in the operation of a business with which your investment is connected may reduce or eliminate the income- and appreciation- earning capacity of your investment.
Purchasing power risk. Changes in the value of money as an exchange medium, such as through inflation, may decrease the practical value of your invested resource.
Financial risk. Changes in financial markets, particularly in interest rates, may reduce the value of your investment by making it less desirable to others and by making it more expensive for you to maintain.
Types of investments
Four of the most important types of investment are investments in money, equity, debt, and real estate.
Money investments. A money investment is one in which the basic form of the investment remains money. Examples are: deposit accounts, certificates of deposit, money funds, and annuities. The basic reward from a money investment comes in the form of interest. Money investments are relatively safe, with correspondingly conservative rates of return.
Debt investments. A debt investment is one in which an investor buys a debt instrument. Examples are bonds, notes, mortgages, and bond mutual funds. The basic reward comes in the form of interest. Debt investments are usually riskier than money investments and less risky than stocks or real estate.
Equity investments. An equity investment is one in which an investor buys an ownership interest in a business concern. Examples are stocks and stock mutual funds. The basic rewards come in the form of dividends and appreciation of share value. Equity investments are generally riskier than money and debt investments.
Real estate investments. A real estate investment is one in which an investor buys real estate for its investment benefits rather than primarily for its utility. It may have the features of both an equity and debt investment, depending on the type of real estate involved and numerous other factors, such as the type of interest one owns. A real estate investor may invest in an income-producing property or a non-income producing property.
- non-income property
a residential property used as the investor’s primary residence. The basic reward, beyondthe enjoyment of use, comes in the form of appreciation. There may also be tax benefits, depending on how the purchase is financed.
- income property
a property owned specifically for the investment rewards it offers. Examples are multi-family residential properties, retail stores, industrial properties, and office buildings. Rewards come in any or all of the forms mentioned earlier: income, appreciation, leverage and tax advantages.
