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Investment Theory

Updated on April 4, 2024
Article byAswathi Jayachandran
Edited byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Investment Theory?

Investment theory suggests that an investment is an adjustment to the capital stock over a specific period. Here, investment is a flow concept, not a stock concept like capital. This implies that capital is computed by taking a short period into account, while investments are computed over a lengthy period.

Investment Theory

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Economists have long realized the tendency of investment to be the most volatile of the expenditure components over the business cycle. As a result, many business cycle theories strongly emphasize investment expenditures and their understanding. An individual investor may use a variety of investment theories and strategies to gain maximum profit.

Key Takeaways

  • Investment theory is framed on the basic idea that investment changes capital stock over a specific period. Accelerator Theory Of Investment, Internal Funds Theory Of Investment, and Neoclassical Theory Of Investment are three major types of investment theories.
  • These theories can be used by representative parties to establish their views on the nature of the financial markets and make decisions to reach their broad goals.
  • Modern portfolio theory, dollar-cost averaging, the law of big numbers, dividend reinvestment, and ideas contribute to reducing risks in an investment portfolio’s stock section of individuals.

Investment Theory Explained

Investment theory is framed with the basic idea that investment changes capital stock over a specific period. However, investment is a flow concept, not a stock concept, according to investment theory. Capital stock differences between the end and the beginning help calculate investment flows over a specific time. Strong correlations between investment and output indicate that the two variables have the propensity to move together. However, they do not enable us to identify the directions of causality.

To analyze the data, we require the framework provided by economic theory. Due to the high level of investment volatility, some economists have concluded that changes in the demand for investments significantly contribute to business cycles. Others have claimed that the huge range in investment over the cycle reflects consumption smoothing, which results in squeezing out of the investment as households keep their consumption expenditures at a high level during economic recessions.

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Keynesian And Hayekian Approaches

Keynesian and Hayekian approaches are the two main ways to view investments. From a Hayekian perspective, investment is an adjustment that is in opposition to equilibrium. This implies that choosing the right speed to make the change is the essence of optimal investing.

The Keynesian economics approach to investing emphasizes behavioral factors more than adjustment. The Keynes investment theory states that the company calculates the ideal investing level by considering the capital’s interest rate and marginal efficiency. In other words, it claims that the business determines investment levels so that the market price of capital goods and the demand price are equal. This investment behavior suggests that a firm calculates its outstanding capital stock by maximizing the current value of its capital stock and labor inputs. In other words, Keynes’s investment theory does not differ from the neo-classical theory of corporate behavior.

On the other hand, an individual investor may use a variety of investment theories and strategies. Passive and active strategies are the two primary categories of strategies. Asset allocation, diversification, and identification of asset classes are just a few crucial steps in creating an investment portfolio. Modern portfolio theory (modern investment theory), dollar-cost averaging, the law of big numbers, dividend reinvestment, and other ideas contribute to reducing risks in an investment portfolio’s stock section. The utilization of leverage, short sales, and options strategies are examples of advanced strategies.

Types

The three major types of investment theories are as follows:

#1 – The Accelerator Theory Of Investment

 In its most basic version, economists predicate the accelerator theory of investment on the idea that a certain amount of capital stock is necessary to achieve a specific output. A few major points to note are that the theory explains net investment, not gross investment.

According to the theory, any mismatch between desired and actual capital stocks will be resolved within a single time frame. Therefore, the acceleration principle assumes a stable ratio between capital and output. Since the theory doesn’t account for surplus capacity and may not be valid, one cannot anticipate it to hold in a recession. The hypothesis states that as output increases, net investment is positive. However, if there is excess capacity, little to no net investment may occur because net investment raises production capacity.

#2 – The Internal Funds Theory of Investment

The internal fund investment theory postulates that the profit level determines the required capital stock. According to this, investment strongly correlates with expected profits, suggesting that investment depends positively on realized profits.

#3 – The Neoclassical Theory of Investment

The neoclassical investment theory of optimal capital accumulation serves as this theoretical underpinning. It states that output and the cost of capital services about the cost of output determine the desirable capital stock. The cost of capital goods, the interest rate, corporate income taxation, etc., influence the cost of capital services. As a result, changes in the result or the cost of capital services relative to the cost of output influence the desired capital stock and, therefore, investment.

International Trade And Investment Theory

The study of international commerce’s patterns, causes, and welfare effects is known as international trade theory. It is a subfield of economics. International trade theories are merely explanations for international trade. Exchanging commodities and services between two or more parties is the idea of trade execution.

The idea of this interchange between individuals or groups operating in two distinct nations is known as international trade. Individuals or organizations exchange goods or services because they think they will profit from them. They can be in need or want of the products or services. While this may appear relatively straightforward, a lot of theoretical government regulation and business strategy goes into international trade. Some of those theories are as follows:

Consumption And Investment Theory

Investment and consumption are interrelated. Investments are the sum of any income received minus the amount consumed. Keynes’ theory of consumption, commonly known as “absolute income theory,” emphasizes the absolute size of income as a factor in determining consumption.

In addition, Keynes proposed a psychological rule of consumption, which states that when income rises, consumption climbs too, but not as much as the growth in income. In other words, the marginal propensity to consume is below one.

Saving And Investment Theory

Saving and investment theory is also referred to as income theory and was first used by economist Thomas Tooke. The main goal here is to explain variations in the price level or the value of money as per the classical investment theory view, assuming that the economy is always in full employment equilibrium. It also operates under the presumption that investments and savings are equal.

Interest rates contribute to the parity between saving and investing. A shift in interest causes changes in savings and investments, respectively. The interest rate decreases to deter and promote investment when saving outpaces investments, and vice versa.

Frequently Asked Questions (FAQs)

Why is investment theory important?

Trustees, fiduciaries, and other representative parties can define their views on the nature of the financial markets they must operate in, how these markets operate, and the actions they plan with the aid of these theories. It acts as a link between high-level objectives and practical decision-making.

What is the investment theory of creativity?

The investing theory is based on the assumption that creative people choose to buy low and sell high in the realm of ideas; that is, they produce ideas that tend to “defy the crowd” (purchase low), and then, after persuading many people, they sell high, meaning they move on to the next controversial idea.

Who came up with the investment theory?

Classical investment theory began with Fisher; Irving Fisher’s original investing theory was initially intended to be a capital theory. He assumed that all capital was in circulation. Later, John Maynard Keynes (1936) adopted a similar stance. However, Keynes was largely responsible for the investment decision.

This article has been a guide to what is Investment Theory. We explain the topic, including its relation with international trade, saving, consumption, & its types. You may also find some useful articles here –

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