An investment is a commitment of resources in an effort to achieve later benefits. This is mostly financial although it can be done within a business.
Most often it is the acquisition of an asset with the goal of creating income or appreciation. Investors are seeking a return on the money they put in.
Speculation
Speculation is the most obvious form of return when investing.
When engaged in this, investors seek to financially benefit from the price appreciation of an asset. Over time, as markets move higher, the value of one's portfolio can grow.
One needs to factor in risk when utilizing this approach. Assets can appreciate in price yet they can also decline.
Investors also have to factor the overall trend of the market, whether it is a bull or bear. Capital flow and the economy are also variables that can impact market moves.
Long term price appreciation is a tool that many use for wealth building.
The profits made from this type of activity is known as capital gains. It is applied in many countries for tax purposes.
Yield
Another class of investments are known as yield.
This is the purchase of fixed income instruments such as a bond or certificate of deposit (CD). Price appreciation is not the main focus and, often, is not even part of the investor's focus.
The asset provides a stream of payments. This is usually in the form of interest. Some will purchase stocks that pay a dividend as a way of improving the yield they receive.
Fixed income products tend to be good for a fixed period of time. After that, the initial amount if returned at maturity in addition to the final interest payment.
Yield is always denotes as a percentage, usually over the period of 12 months. Annual percentage return (APR) is what it is stated in although it could be annual percentage yield (APY).
Investment Vehicles
Some of the different investment vehicles that people can use:
- Stocks
- Bonds
- Cryptocurrency
- Commodities
- Options
- Futures
- Exchange Traded Funds (ETFs)
- NFTs
- Real Estate
- Precious Metals including Gold and Silver
- Mutual Funds
An investment is a long term purchase whereas a trade is done with a short term horizon in mind.
Business Investment
Investments regarding an enterprise can take place both in a business or within it.
Many prefer to invest directly in private businesses, seeking a return. This can be in the form of monetary but could also include other forms of payment as time, expertise, or the use of facilities.
This could be structured in a way where the investor has an equity stake in the business.
Within a business, investment is often made by the entity to grow revenues. This can be in the form of entering new markets, developing different products, or hiring more people to gain market share. It could also be the using of capital to buy other companies.
The goal is to increase the cash flow of the business by expanding operations in some way.
Counterparty Risk
All financial transactions have counterparty risk. The other side of the trade requires trust it will fulfill the terms of its commitment.
Even with savings, which has the least amount of risk, relies upon the solvency of the bank. Sovereign debt does the same with the country that is issuing it.
Investments are sized up based upon risk. This means comparing them to a standard. Most use the 10-Y U.S. Treasury bond is considered a risk-free investment. All other investments are compared to this asset for the assessing of counterparty risk.
The financial system is based upon trust and measures are taken to ensure it. Regulation is formed around the premise of helping investors feel confident in the system.
Counterparty risk is something many investors overlook. It is only after financial institutions encounter solvency issues that they become concerned. The fallout from the Great Financial Crisis (GFC) showed that investment banks often ignore this risk.
The fate of Lehman Brothers and Bear Stearns show how this can cause implosions to the tune of billions of dollars.
Derivatives
Derivatives are investments vehicles that can be used for a variety of purposes.
The first use of derivatives is to hedge positions. For example, there is risk associated with FOREX. Companies often by foreign exchange derivatives to hedge against the risk of currency loss.
Farmers and producers of other commodities often sell their products for pre-arranged prices. The use of the futures market hedges against a price decline.
This transfers the risk to the investor in the contracts, something that allows them to profit is prices do move up.
Another use is for leverage. When investors take positions, a derivative such as an option can leverage the return. This means a larger payoff if the market action aligns with the position taken.