Investopedia has a great definition, full of lovely jargon: An asset or item that is purchased with the hope that it will generate income or appreciate in the future.
In simple terms
What do we need? We need an asset which in our context, is simply an economic resource, which can produce value (e.g. cashflow). Assets can be tangible (land, buildings, equipment, commodities, etc) , intangible (patents, brand, knowhow, educational degree, etc).
How do we profit from it? This asset is acquired today at a certain cost, and can be exchanged for a higher consideration in the future. The asset can be utilized to generate benefits: regular income over time or a one time sale to make a profit. We forgo using up the asset today so that we can create future wealth from it.
Is it certain that we will make a profit? No, there is a only a hope, or probability, or potential, usually no certainty. Simplistically, one has to make a compromise between risk and return. Usually higher the risk (or lower the probability), higher the potential return. Conversely, lower the risk (or higher the probability), lower the potential return.
When is it really an investment? At the very least, real returns should be greater than 0. In other words, the after-tax returns should be greater than inflation. This is probably the most important aspect than an investor must learn and we will return to it later in this article.
When is it not an investment?
This may be illustrated with some examples:
- Savings accounts: leaving money idle in bank account. Might as well shoot yourself in the foot right now and be done with it.
- Consumption purchases: cars, household equipment, etc which are meant for everyday use and depreciates with time. Only mugs make bombastic statements like, oooo, I “invested” in a car.
- Buying a house using leverage (in simple terms EMI) to live in. This is another favorite Indian fallacy. We’ll be dissing this in depth in future articles.
- Insurance: Ah how we love insurance companies peddling their garbage insurance and investment instruments, and hordes of junta falling for it.
- Gambling: Betcha you knew that already. You, gentle reader are smart. That’s why you are on this site.
Broadly there are two types of investments
Equity investment: complete or partial ownership of an asset, and profit is earned based on the performance of that asset. One could have complete ownership as an owner / partner of a business or company. For the retail investor, it usually means buying stock or equity mutual funds, which allow one to take part ownership in a company, albeit a very very tiny part usually. Equity investment returns are not known in advance or guaranteed and depend on company performance. Profit (or loss) is based on upon the rise (or fall) of the underlying shares and the dividends (if any) issued by the company.
Debt investment: lending to persons, firms, or a government institution via bonds, NCDs, mutual funds, etc. Returns are usually known in advance, but may not be guaranteed. Returns are not dependent on the performance of the borrower. Bank accounts are examples of debt investments.
Other types of investment
Real estate investment: We hate real estate investments and shall forbid our gentle readers from investing in the same.
Options/Futures: Lets not even go there yet.
Forex: Trading in foreign exchange
Gold or other commodities
Precious objects like paintings, jewellery
Equity investments have higher volatility of returns when measures over shorter periods of time (< 5 years)
Debt investments are considered lower risk, and hence provide lower rates of return than equity
Debt investments usually have real returns < 0, i.e. the annual percentage return of a debt instrument is usually lower than the rate of inflation, and hence one usually loses wealth by investing in debt instruments!
An intelligent investor must invest in a basket of investment avenues, thus creating a portfolio, towards meeting their goal(s).