Investment

Updated on March 27, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Investment?

Investments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later. Generally accrued over a period, investments can generate either profits or losses. They can be made by individuals and entities alike. 

The income generated can fulfill financial goals by meeting shortages in income, debt repayment, education or student loans, etc. Investors can use it to purchase further assets that generate additional income and further investment. It fulfills the aspirations of increasing revenue without working hard for the same.

Key Takeaways

  • Investments are usually assets that one purchases now with the hopes of greater returns in the future. They postpone its consumption today for the sake of future rewards.
  • The main purpose of investing is to earn profits. People can utilize it to satisfy financial objectives such as income inadequacies, debt repayments, education or student loan repayment, etc. Investors can also use it to buy more assets that generate more revenue.
  • Smart investments can help investors earn more money, gain financial stability, and achieve financial goals. People can accomplish this through the compounding nature and inflation-beating returns.

Investment Explained

How an Investments Works

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Investments are another form of savings, except that they generate an attractive rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more. They can grow into more than what they were initially worth. Assets can be stock market investment, precious metals, land, real estate investment, etc. They generate income in two ways. One is through profit if it is in a saleable asset, and the other is through gain accrual if it is in a return-generating plan.

A person can invest for various reasons. The primary goal is, however, to gain high returns. It can be through yield plus capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more (the difference between purchase and sale price). DividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more and interest received are examples of such yields. The returns are subject to various conditions, including the maturity period, the type of investment, and the risk involved. Investors also invest for liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more since a liquid assetLiquid AssetLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet.read more is easily convertible into cash within a short period. When liquidity is high, then returns may be less. 

Saving and investing are related to each other even though, from an economic standpoint, investing and saving are distinct concepts. Savings refers to any income that is not spent on consumption, regardless of whether they are being invested for greater returns. As a result, individuals’ investment, saving, and consumption values might differ during a given specific period.

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Effects of Investment

It’s not just the individuals who invest; companies also make investments. Corporate and capital investments enhance the economy’s capacity to produce. They result in economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more. If there is no investment activity in the economy, it can result in unemployment. But there are negative effects to over-investing too. If investing exceeds savings, inflation occurs. Investing has effects on both individuals and economies. It is not a good sign if an economy comes to depend on investments alone for its income generation.

There is always a certain degree of risk that comes with investments. Wrong investment decisions can make someone lose their hard-earned money. Therefore, the smart investment includes considering the safety factors too. Individuals who prefer to keep cash safe for adequate returns choose to invest in government bondsGovernment BondsA government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income.read more

Types of Investment

Investments are broadly classified into:

#1 – Stock Market Investment

Commonly known as stocks or shares, equity securities represent an ownership interest in a company. A shareholderShareholderA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more is an investor who owns a share/stock in a company. They usually receive payment last in liquidation or winding up of the company. After that, they receive whatever remains after paying creditors, the government, etc. Holding stocks pay dividends. Dividends are profits that companies distribute to their shareholders.

#2 – Investment in Debt securities

Debt securities are otherwise known as “fixed-income securities.” They give periodic returns until the maturity date. Bonds belong to this category. A bond is a contractual obligation of the seller to repay the buyer a certain amount of interest plus the principal on the maturity date. Some instruments do not pay periodic interest, such as discounted bonds. Instead, people sell them at a discount and return their original value to investors. Other instruments include treasury bills, corporate and government bonds, etc.

#3 – Investments in Derivative Securities

It is otherwise known as “contingent claims.” They derive their values from the underlying security or assets. Options and futures are two such securities. OptionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read more provide rights to traders to buy or sell, but there is no obligation to do so. Call optionsCall OptionsA call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration).read more are to buy, and put options are to sell. A futures contract comes with an obligation to buy or sell the asset at a predetermined price and time. 

Examples

Check out these examples for a better idea:

Example #1 – Return on Investment

Let’s take the example of two friends, David and Daniel. David invested $10000 at the age of 25, and his friend Daniel started investing with the same $10000 at the age of 35. When they were fifty, David had $33,863.55, and Daniel had $20,789.28 with him. Even though both friends invested the same amount of money with the same interest rate, David had more money. This is because he had started investing long before Daniel. The amount carries the compounding interest difference of ten years between the friends. Compounding interestCompounding InterestCompound interest is the interest charged on the sum of the principal amount and the total interest amassed on it so far. It plays a crucial role in generating higher rewards from an investment.read more increased the profit, or otherwise the return on investment collected by David. This example demonstrates the power of investing for longer periods.

Example #2 – Smart Investment

Harry and Jerry wanted to invest their game-winning money. Both wanted these investments to serve emergency purposes. Harry invested in shares of a company, and Jerry chose to invest in the real estate sector, thinking it would give high returns. When an emergency struck, Harry sold his shares and received cash. Unfortunately for Jerry, selling real estateReal EstateAt its most basic principle, Real Estate can be defined as properties that comprise land and its tangible attachments. The land includes the actual surface of the earth and any permanent natural objects such as water, dirt, or rock and any minerals or particulars under the surface. read more required a significant amount of time and paperwork, so he could not sell it in an emergency. This example demonstrates the essence of knowing the goal and the means to invest in it. Harry had chosen a high liquidity asset, which would be appropriate as the goal was “to serve in an emergency.” After thorough research and analysis, investors should make similar decisions considering the purpose, risk involved, the factor of liquidity, etc.

Importance of Investment

The importance of investing is more apparent when one examines the differences between saving and investing. Savings are cash that one puts in safe places such as savings accounts, certificates of deposit, etc. They allow access to an individual’s money at any time. The security factor and availability pay less interest. If one leaves the money (with interest) in place for an extended period, they do not keep pace with inflation.

For example, suppose the savings can buy a bottle of water today for $1, and that one dollar, along with interest accrued, can only buy half a bottle of water after a few years. This is the effect of inflation. Here, the value of money decreases. Therefore, investing is a way out. Clearly, it can provide returns that cover inflation, saves tax, and much more. Investing can, thus, reward individuals (and entities) more for the risk involved, especially if the investment is long-term.

Importance of Investment

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Investing provides individuals with financial security, and selling off assets can provide a getaway from a financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more. It provides financial independence. Reinvesting the existing dividends and interest can earn more and more returns. ReinvestingReinvestingReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio.read more the returns is how a person can build wealthWealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation.read more. Investing also helps individuals achieve their personal and financial goalsFinancial GoalsFinancial goals are targets set by an individual to achieve financial milestones or plans. In other words, they are financial objectives that an individual wishes to accomplish within a certain time frame.read more. Smart investment choices can help investors achieve short-term, medium-term, and long-term goals.

Frequently Asked Questions (FAQs)

Why is investment important?

Smart investments provide additional income, financial security, and the achievement of financial goals. It is achieved through inflation-beating returns and the compounding nature of these investments.

Which investment has the least liquidity?

The liquidity concept refers to the ease at which a given asset can be converted into cash in terms of time and cost. For example, land and real estate investment are the least liquid as they take several months to years to be sold.

How are investments taxed?

Interest, dividends, capital gains, rental and royalty income, and non-qualified annuities are all examples of net investment income. If the investor earns more than the threshold amount, individuals must report the net investment income tax in Form 8960. The form helps in calculating the amount of taxable investment income.

Is investment an asset?

Assets are instruments that generate income or profit. Unless investments result in losses, they are considered assets as they accrue benefits over time.

This has been a guide to Investment and its Meaning. Here we learn the types of investments, their explanations, importance and examples. You can learn more from the following articles – 

Reader Interactions

Comments

  1. Rebecca Anayire Asibi says

    Thanks for the information. It’s has really help me. I think I will make the right choice.

  2. Jackson Okoth Ochen says

    Very interesting and valuable

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