What is an Investment?

what-is-investmentInvestment is a word that is so regularly used that few people bother to think about its exact meaning when they use the word. And yet, investment is a word that is very difficult to define. Indeed, in the course on investment management which is taught by this writer at USM, a whole hour is taken up to discuss the meaning of an invests meat with the students.

An investment may be defined as:

The exchange of cash for an asset with the hope that the asset will yield. regular future income and/or an increase in the value of the asset such that the sum of the income and the eventual value of the asset is greater than its purchase price.

{would like to draw your attention to the word “hope” in the above definition. Right from the start, I must stress that in most investments. we have no guarantee of the future income. Anyone who can guarantee you a certain return on, say, the stock market, is either lying or stupid. The regular income and/or the increase in the value of the asset is known as the “return on investment”. The first is usually known as the “current income” while the second is known as the “capital gain”. By this definition, there can be many types of investment. Putting money in a savings account is investment; buying a house is an investment; investing in shares is an investment; and even keeping money under one’s pillow is an investment. (Please do not think I am joking. Putting one’s money under the pillow can be an excellent investment during a time of deflation, that is a period when the prices of goods are generally decreasing.)

Since there are so many types of investment, how should one decide in favour of one form of investment as opposed to another. We have all heard of people who have doubled their money or more in the stockmarket over a short period of time. If so, why should anyone even consider putting his money in a savings account yielding a miserable 4 per cent or so (at the time of writing) interest per year? The answer to this question is that the opportunity of obtaining a big return alone is not the only consideration when one is making an investment however big that return potential may be. After all, the most profitable investment one can possibly make is the smuggling of heroin but how many of us would even think of such an investment. An investment has three other important characteristics which an investor has to weigh as well when he is making up his mind. Most people do this instinctively without consciously realizing what they are doing. But to be better than a mediocre investor, one has to weigh these three factors consciously and intelligently. The three characteristics are liquidity, uncer~ tainty and the split of return between regular income versus capital gain Each of these characteristics as manifested in a particular type of investment may not necessarily be attractive to an investor. The attractiveness of a particular investment in terms of each of these three characteristics usually determines the size of the return that an investor can expect to get from this investment and it also determines whether a particular type of investment is suitable for him.

In the final analysis, one must remember that investments are much like any other commodities, its behavior must obey the laws of economics, more in particular, the law of supply and demand. If a type of investment is very attractive, there will be a lot more demand for it and in the face of such demand, its price will increase hence reducing the available return from it such that it becomes less attractive and thus choking off the excess demand. Over the last fifteen years, stock market investment has consistently provided much higher return than long term fixed deposit and yet many people are still putting their

money in fixed deposits. This must mean that the other factors involved negates the attraction of high return of stock investment to some extent. Let us look at these three characteristics of an investment more carefully, in particular, how they are manifested in shares investment.

(a) Liquidity is a word used by economists to describe how easily an asset can be turned into cash. An investment is liquid if it can be quickly turned into cash. Thus, a savings account is a very liquid investment. But some investments are very illiquid. The more illiquid an investment, the less attractive it is.

(b) An investment involves uncertainty regarding the size or even the possibility of the future gain. The greater the uncertainty regarding its future return, the less attractive is an investment.

(c) An investment usually produces a combination in different prepartions of two types of income; a regular income and a capital gain resulting from the increase in the value of the asset. The smaller is the proportion of returns from the regular income, the less attractive is the investment.

Let us examine in detail next post about how these three characteristics of investment in general and with regard to shares in particular can affect the return one may expect to get.

Leave a Reply

Your email address will not be published. Required fields are marked *