Beginner Lessons Lessons 1-5

Lesson 2: What is an Investment?

Let’s begin with a pretty basic idea and define what an investment is. You have probably heard “John bought Apple stock years ago that turned out to be a great investment” or “by earning a college degree I am investing in myself.”

An investment in its simplest terms is a purchasing of an asset in with relative certainty that the asset you purchase will generate income and/or increase in value.  Another way of looking at an investment is that you are sacrificing immediate consumption in hopes of a greater payoff at some point in the future.  Let’s go through some examples to paint a clearer picture.

Key Points

  • An investment is an asset that will either increase in value and/or generate income.
  • Returns are how we measure how “good” or “bad” an investment is.

Investment Examples:

  • A House: A house or any other piece of land purchased could be considered an investment if you believe that over time the house will increase in value.
  • A Car: A car is not generally considered an investment.  A car almost certainly loses value over the long run (this process is generally referred to as depreciation) the exception to this would be you buy a car in hopes that thirty years down the line it becomes a classic and can sell for a high price.  “But wait Colby,” I hear you saying “I use my car to go to work and make money. Isn’t that generating income for me.” An interesting argument but I would say that the car is still not an investment because the car as an object is not generating income (that is you do not turn the car on and money begins to shoot out of the exhaust pipe) it is enabling you to generate an income but it itself will probably result in you paying money into the car in the form of gas, upkeep, etc.
  • Stocks, Bonds, Mutual Funds: These are all financial assets and are probably the most commonly associated terms when it comes to “investments”. I wanted to wait to mention these because we are going to dive in depth about each of these and how they are investments in lessons to come. For now just know that when people speak of investments they generally refer to financial asset investments.
  • Rare paintings, Stamps, Collectible Cards: These and other “rare items” could be considered investments if you believe after a certain amount of time you could sell them for a higher price than you bought them. That being said I would not suggest you invest your life-savings into buying up the art of an up-and-coming avant-garde artist in hopes of striking it big. There are safer things to do with money you could invest.

A Bit About Returns

Ok so after consideration you decided to not heed my warning and bought that strange new painting from that avant-garde artist because you know “he’s just underappreciated,” and that’s fine it is your money after all. Now did that investment make you money and if so how to me measure its performance as an investment versus if you would have instead bought a piece of land with that money? In the world of finance the measuring stick we use is the idea of returns. An important point about returns is that they are generally reported in percentage form.  Now there are a lot of complications with returns but let’s see an example and apply some easy numbers.

 Return Situation A

You spent $10,000 accumulating art of Mr. Veray Artsay (that avant-garde artist).  Five years later the art community has realized what an artistic genius Mr. Artsay is and you are able to sale the art you have to a wealthy art collector for $50,000.  Your return is calculated as follows:

(New Value of the Art – Old Value of the Art)/ Old Value of the Art

Now with Numbers:

($50,000 – $10,000) / $10,000 = 4 or 400%

You earned a 400% return, not too shabby you art connoisseur, but let’s consider a not so happy situation.

Return Situation B

You spent $10,000 accumulating art of Mr. Veray Artsay. Five years later the art community believes that Mr. Artsay is a talentless hack and you are able to sale the art you have at a garage sale for $1,000.  Your return is calculated as follows:

(New Value of the Art – Old Value of the Art)/ Old Value of the Art

Now with Numbers:

($1,000 – $10,000) / $10,000 = -0.90 or -90%

You earned a -90% return which is…not so good. Noting that the return is negative because the value of the art decreased over the time period. Another way to look at it is that you have lost 90% of the initial money you invested in the art.

These are very simplified examples as we did not assume we have an investment that will generate any income. We assumed that all we have to care about is the price change over time. When the investment generates income it gets a little more complicated.

Definitions

  1. Investment: The purchasing of an asset with relative certainty that the asset you purchase will generate income and/or increase in value  (other common terms for investments are “securities” and “assets”).
  2. Rate of Return: The percentage of increase or decrease in the total value of an investment compared to its initial investment cost.

Further Reading

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