What’s an Investment?

Oct 3, 2012 by

the yellow brick road

It’s always best to start at the beginning.

Embarrassed, intimidated, or uneasy because you know absolutely nothing about investments? No worries! Here’s a place to start: With some fundamental concepts.

What Is an Investment Anyway?

An investment is anything you can own—an asset—that can appreciate, or go up, in value or pay you cash, like dividends, rent, or interest.

Why Would You Buy an Investment?

You buy an investment because you want to make money over time. The money you could make, or your return on investment, comes in one or both of two forms:

  • A Capital Gain  The market value, or what someone else is willing to pay for the asset, rises over time. You pocket the difference between what you sell the asset for and what you paid for it. The amount you pocket is your capital gain (or capital loss, if the asset went down in value).
  • An Income Stream  Any cash that comes to you regularly because you own the asset. Maybe it’s rent from a townhouse you own, or interest from a Certificate of Deposit or bond, or dividends from stock you own in a company, or cash flow from a business you own.

You must accept one simple fact before investing in anything: Every investment’s market value can go down.

All Investments Involve Risk

When you want to sell your investment, you may not be able to find anyone willing to pay you what you paid for it, or even to pay you anything at all for your asset. You can lose money on investments—up to 100% of what you paid. This possibility is part of the risk of an investment.

Some investments are very risky. This means there’s a high chance—compared to all investment options—of you losing some or all of your money. Other investments carry a low risk of you losing the money you pay for the asset. The flipside is that, in general, high-risk investments can—not will—give you a higher return than low-risk investments. But take care: All investments carry risk that you will lose some or all of the money you spent to buy the asset.

Investment Advice

Be smart about investment advice. Only you put first your own family’s interests. Don’t ignore suggestions from those who stand to profit from your investment decisions, including the decision of whether to invest at all, but understand their motivations and gather information from different sources. Mostly, do your own self-education and research, or hire a fee-based Certified Financial Planner.

Liquidity and Volatility

When choosing investments, you’ll want to think about liquidity and volatility.

Liquidity means how easily an asset you own can be sold for cash. For example, a share of General Motors stock is quite liquid. You could sell it immediately anytime the stock exchange is open. A small business or rental property is very illiquid. Months or even years might pass before you can sell the asset.

Volatility refers to how regularly and by how much the value of an asset jumps up and down. The price of oil, for example, is quite volatile, often changing several percentage points in a day. The value of your car on the other hand is not very volatile. What it’s worth one week is never very different from what it was worth the prior week. Unless of course you happen to wreck it.

Why Liquidity and Volatility Matter

The universe of suitable investment options depends on which of your savings pools—Emergency, Planned, Retirement, Medical, or College Education—the cash will come from to make the investment. For example, by its nature, it’s impossible to know when you might need to use your Emergency Savings fund. So your Emergency Savings fund should always be easily, quickly, and painlessly turned into cash that you can spend. And you don’t want to find—just when you need it—that your Emergency Fund’s value has been cut in half, so the Fund shouldn’t be invested in anything volatile, even if it’s liquid. On the other hand, you might invest your Retirement Savings or College Savings in assets somewhat more volatile and less liquid, depending partly on how many years until you plan to retire or your kid goes to college and your risk aversion.

The rule to keep in mind is this: You want to keep low the likelihood that you’ll be forced to sell an investment at a loss, or finding you can’t sell an investment at all, when the time comes to convert your investment to cash for spending. The longer into the future until you’ll want to sell an investment to raise cash for spending, the less you need to think about liquidity and volatility.

What Have I Left Out?

Do you have any key basics of investments you’d like to add?

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  • William_Drop_Dead_Money

    Good synopsis. I would add that any investment (rental property or securities) will require some time/work. There’s no “set it and forget it” investment. As with all such things, there’s a correlation between the amount of time put in and the return.

  • frugalportland

    only you put first your family’s interests — well said!

  • William – very good point, thank you.
    Frugal P – why thank you!

  • John S @ Frugal Rules

    Great tips. I totally agree that you are the only one that’ll put your family’s interests first. I’d also add the importance of doing your own research to make sure you’re comfortable with what you’re investing in.

  • Andy Hough

    That is a good summary of what is an investment. Many people don’t give as much consideration to liquidity and volatility when investing as they should.

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