Investment

What is an Investment?

As a term, investment holds many different meanings in finance and business. With regards to finance, an investment is any asset or instrument that an investor purchases or sells with the expectation of earning a monetary profit. Financial investments, upon analysis, are attached with a high degree of security for the principal amount (the total amount invested), as well as a security of return within an expected period of time. The practice of thorough analysis is a necessary component of financial investing—all investors must practice prudence when investing.

Investing is related to deferring consumption or saving. In business, investment occurs when a producer purchases a physical or working good, such as inventory or equipment, in the hope of improving future sales. This behavior is distinct from financial investing; business investing uses money to purchase a good that is re-sold at a higher price in the future, while financial investing uses money to purchase an abstract right or proof of ownership in the hopes of making more money. Common examples of financial investments include the purchase of stocks, bonds or options.

As an investor, your main considerations—besides choosing which investment types are right for you—are found in the areas of taxes, inflation, asset allocation and risk management. It is always desirable to maintain a diversified portfolio. If you are overly exposed to one asset class or to a particular industry you will be susceptible to tremendous losses.

Investment Advice for Beginners:

Types of Investments:

For first time investors, it is essential to understand the basics. Before you go out and throw your money around you should research the different types of investment. Stocks, bonds, mutual funds, property, currency and options are all popular forms of investment that individuals procure to generate profits. That being said, like all forms of investment, each vehicle is attached with risk and variables that influence your rate of return.

The three basic asset categories concerning investments are as follows: cash, bonds and stocks.

Cash: The primary advantage of cash is that funds are liquid. Cash equivalents will also allow investors to secure interest or dividends. Forms of cash investments include Certificates of Deposit (CDs) and Treasury bills.

Bonds: These types of debt instruments are issued by government agencies or corporations to finance certain aspects of their operation. When you invest in a bond, you are lending money to the issuer, entitling to secure interest on the loan and a guarantee that your principal (original amount lent) will be repaid when the bond matures. Bonds come in a variety of forms, including municipal bonds (issued by towns or districts), corporate bonds (issued by companies) or treasury bonds (issued by the federal government). Bonds, because of their relative safeness, are attached with fixed rates of return that are considerably less than the potential profit offered by stocks or other investment strategies. That being said, the rate of return for a bond investment is typically higher than certificates of deposits or savings accounts.

Stocks: Shares of stock represent ownership in a corporation. Investment advice for beginners will state that investing in stocks should not be taken lightly—due diligence is necessary to secure a solid portfolio. Stocks will fall under multiple categories depending on the prospect of the company, the size, and the state of the markets. Categories for stocks include: value stocks (high potential for growth), growth stocks and large, mid, and small-capitalization stocks (these categories relate to the size of the company).

The Nature of Stocks:

Over the long run, stocks have historically outperformed all other investment types. Investment advice will dictate that investing in the S&P 500, over the long haul, is the safest and most profitable return on investment (average of 9.8% from 1926 to 2010). The next best performing asset class would be bonds: long-term U.S. treasury bonds return 5.4% on average over the same timeframe.

The biggest determiner of stock price—and your rate of return—is earnings. Over the short-run, stock prices fluctuated based on a number of factors (from interest rates to investor confidence), however, over the long-run, what matters most are earnings.

Although stocks may seem like the best investment strategy, over the short term they are particularly risky. Stocks are highly elastic not only to the underlying company of which the stock represents, but also, to the macro-economy. Dips in company earnings or negative macro outlooks could plummet holdings. Given the frailty of the domestic and global markets, investing in stocks is currently risky—in 2009, stocks overall lost almost 40%. However, with risk comes reward. Although the stock market is far riskier than other fixed-income investments--that typically guarantee a percentage rate of return--investing in stocks will yield higher profits if the stocks perform well.

The biggest determiner of stock price—and your rate of return—are earnings. Over the short-run, stock prices fluctuated based on a number of factors (from interest rates to investor confidence), however, over the long-run, what matters most are earnings.

As stated above, stocks are far riskier investment types than bonds or other fixed-income assets. A bad year for bonds would be a minimal hit to the stock market. For example, in 1994, the worst year for bonds in recent history, Treasury securities fell only 1.8%.

Assessing Risk:

Risk refers to the possibility that you may lose all or all of your investment. Several factors should influence your willingness to take on risk, including your age, financial situation, financial goals and your time horizon. Before you dive-in to the markets, investing for beginners will state that you must first determine your risk tolerance. To do this, evaluate the following questions:

• Are you willing to tolerate greater volatility for the chance of securing higher returns?

• Do you place a greater emphasis on quality, with diminished risk?

Inflation and Taxes:

Inflation and taxes are two important considerations that must always stay on the mind of investors. Inflation is the perpetual increase in the cost of goods and services. For your income to grow in “real terms” your investments must outpace the rate of inflation. Moreover, solid investment advice will always consider the effect of taxation. There are an assortment of investment vehicles that provide tax benefits; these investments are typically tax-free, tax-deferred or tax-deductible.

NEXT: Investment Securities Explained