Fundamentals of Investment

  • Author: Mike Kimbe Go
  • Date Published: 01 March, 2020
  • Source: Investopedia

What Is an Investment?

An investment is an asset or item acquired with the goal of generating income or appreciation. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit.

Understanding Investment

Investing is putting money to work to start or expand a project - or to purchase an asset or interest - where those funds are then put to work, with the goal to income and increased value over time. The term "investment" can refer to any mechanism used for generating future income. In the financial sense, this includes the purchase of bonds, stocks or real estate property among several others. Additionally, a constructed building or other facility used to produce goods can be seen as an investment. The production of goods required to produce other goods may also be seen as investing.

Taking an action in the hopes of raising future revenue can also be considered an investment. For example, when choosing to pursue additional education, the goal is often to increase knowledge and improve skills in the hopes of ultimately producing more income. This is also the main goal of reading articles on Investopedia. Because investing is oriented toward future growth or income, there is risk associated with the investment in the case that it does not pan out or falls short. For instance, investing in a company that ends up going bankrupt or a project that fails. This is what separates investing from saving - saving is accumulating money for future use that is not at risk, while investment is putting money to work for future gain and entails some risk.

How Do Investments Earn Money?

Most investments earn an investor money through appreciation, interest payments or dividends. Appreciation means that the value of an asset has increased. If you purchased a collectible item for $100 and five years later it was worth $500, then the collectible appreciated in value. Securities can do the same -- a stock issued by a company can increase in value over a number of years.

You have likely paid interest payments on a loan you have taken out, whether that was a student loan or mortgage. These interest payments you paid the lender were how the lender earned money on that loan (or investment). One type of security that issues interest payments to its investors is a bond. When you buy a bond, you are lending money to the government or a corporation, who promises to pay you back and make interest payments on the amount you lent.

Dividends are also issued as a payment to investors, but they are made by companies whose stock or equity that you own. Public companies issue stock to raise money for business activities, letting investors purchase these stocks. If you own a stock in a company, that company may also issue dividend payments to you as a way to share its profits with its investors. This is on top of any appreciation in the value of the stock.

Risks with Investing

Even though investing can earn money for you, it is not without risks. The biggest risk with investing is that you may lose the money you invested. Unlike savings or checking accounts, whose value is guaranteed by the Federal Deposit Insurance Corporation (FDIC), investments have no such guarantee.

Certain investments are less risky than others, but all investments carry some amount of risk. The amount of risk also affects the rate of return of an investment, meaning for someone to take on a lot of risk, there must also be the possibility of great reward. Think about it: you would not take a big risk without the possibility a big payoff. Conversely, investments with less risk typically have lower returns. One way that investors reduce their overall risk is by investing in a variety of different securities, such as stocks and bonds, or even in different types of the same security, such as government bonds and corporate bonds. This is known as diversification, and it isan important concept for any investor to understand.

Another big risk in investing is your own emotions. Many investments are volatile in the short term, meaning that their value may fluctuate a lot over one to five years. During economic recessions, the value of many investments may fall dramatically. As an investor, it is difficult to watch your investments lose money. This can lead to investing decisions based on fear or panic, such as selling stocks when the prices fall too low for your comfort.

When you invest, you should be holding most of your investments for ten, twenty or more years. It is over these longer time periods that the value of investments has historically increased. The Standard and Poors 500 (S&P 500), a stock market index, averaged a 7% inflation-adjusted return from 1950 to 2009. Keep this in mind when you make investing decisions. You will perform better as an investor if your investing decisions are based on logic and reason rather than emotions.

You may have heard investing compared to gambling, and if you invest in a lackadaisical way, it may be the same. However, smart investors will approach investing strategically to choose investments that have a good expectation of return. Gambling, on the other hand, is usually based purely on chance.

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