What is an Investment and How it Works?
Investment refers to an asset or item for earning income or appreciation in the future. Appreciation refers to growth in the value of the asset over time. When a good is purchased for investment purposes, the intent may not be to use the good but to earn interest and more value from it in the future. The main reason for investment is to create wealth from an asset, and not to consume it.
There must be an outlay of a resource in the present that includes effort, time, money, or an asset – for greater returns in the future. For example, a monetary asset may provide a profit in the future. So, there is a motive for wealth generation or profit in the future.
Money may be invested in an asset to generate wealth from the increased value of the asset in the future. Therefore, an investment may refer to a process that concerns the increase in the value of assets. This may include buying bonds, stocks, or real estate to earn a greater income in the future. Moreover, buying a property to generate goods can also be termed an investment.
Usually, actions taken to increase the value of returns in the future can also be termed an investment. For example, the time and money spent in earning a college degree is an investment. It will offer a better career and increased returns in the future for the student concerned.
As investment is concerned with the future, there is always a risk associated with it. For example, a company where investors invest their money may go bankrupt. Also, the college degree mentioned above may not fetch a good career in a strong job market in the future.
Usually, investment banks offer a range of services related to investment. Some of these services are intended to provide growth of money to investors to individuals and businesses. Many of these services are meant to increase the profits of investors in the future in comparison to the present value. So, these banks are a good option to put money in for an increase in the value of money.
Types of Investment
There are many options for investors when they intend to invest money. Some of the options are the following:
Stocks can be considered as the units of ownership of a company. When a company earns a profit, the stockholders get a part of the profit via dividends. Also, the market price of the stock may go up with time. This offers additional income for the investor.
There are two types of stocks – common and preferred stocks. Common stock offers voting rights and participation in certain matters of the company. On the other hand, dividends of preferred stocks must be paid before the common stocks’ dividends are distributed.
Additionally, investment in growth stocks is a strategy to invest in smaller companies that have not tasted success yet. In contrast, investment in value stocks is an option to invest in established companies.
Bonds / Fixed Income Securities
Bonds need advance investment and they pay back the returns in recurring amounts for the lifetime of the bond. Once the bond matures, the investor gets the advance payment back. Bonds are issued by many government entities and companies to raise funds. Investors can contribute capital for multiple bonds that offer a positive yield to the investors.
The regular payment awarded to bondholders is known as a coupon payment. As coupon payment remains fixed for bonds, the price of a bond often changes the bond’s yield. For example, a bond paying 5% will be cheaper to buy if market opportunities to earn 6% are there. This occurs through a fall in the price of the bond that makes the bond earn a higher yield.
Index Funds and Mutual Funds
Mutual funds aggregate the companies in whom to invest. Instead of researching and finding companies one at a time, these funds invest money in multiple companies that may be useful for the investors. For example, an investor can invest in small-cap, emerging market funds instead of researching and finding companies to invest in.
The difference between mutual funds and index funds is that index funds are passively managed. In the case of mutual funds, investment professionals try to beat a specific benchmark. In the case of index funds, the idea is to copy or imitate the benchmark. This is why mutual funds are more expensive than index funds.
Real estate investments include investments in physical and tangible assets that can be utilized. Land, office spaces, warehouses, and residential property come under real estate. Investments in real estate are related to developing sites, purchasing residential properties, and utilizing sites for specific uses.
In certain cases, real estate can be referred to as an investment in commodities. For example, investment in farmland may produce crops that are commodities included in the investment.
Commodities are often raw materials that include energy, agriculture, or metals. Investors can invest in actual tangible commodities (such as owning a bar of gold) or can have digital ownership (such as buying a gold ETF).
Commodities are inputs to society. That is the reason why they are called investments. For example, oil, gas, or other forms of energy are input to society as well as investments.
When economic development and growth occur, companies often need greater energy to transfer more products or manufacture increased goods. Additionally, consumers may have a requirement for energy due to travel. So, the price of commodities may increase and yield a profit for an investor.
Investment is an indispensable process for businesses to run smoothly. It not only offers the required funds to start or run the companies, but it also acts as an unavoidable step in the process of production of goods and services. Without investment, companies may find themselves in trouble regarding the funds and hence they may refrain from taking the initiative to run a business. In such cases, investment helps them to stay assured of getting the money required to run the businesses. That is why investment is so useful for businesses.
Q1. What is the difference between mutual and index funds?
Ans. Mutual funds are actively managed while index funds are passively managed. This means that in the case of mutual funds, the investment professionals intend to beat a specific benchmark while in the case of index funds, the idea is to copy or imitate the benchmark. This is the reason why mutual funds are more expensive to fund than index funds.
Q2. Why are commodities considered an investment?
Ans. Commodities are inputs to society which is why they can be considered investments. For example, oil, gas, or other forms of energy that are input to society can be termed investments.
Q3. Why is there a risk associated with investments?
Ans. As investment is concerned with the future growth of income, there is always a risk associated with it. For example, a company where someone has invested may go bankrupt.