Wednesday, February 17, 2010

What is investing?

What is investing?

Investing is the commitment of funds to assets with the objective of making profits either during the life of the investment (dividends in the case of stocks, coupon payments in the case of bonds, etc.) or at the end of it through its appreciation (capital gains).

From a financial standpoint, investments can be made in stocks, bonds, derivatives (such as futures or options), foreign currency and in the money market.

Investments can also be made in non-financial assets such as property, real estate, collectibles, art works, etc. but the markets for these assets are far more illiquid than financial markets and will not be talked about here.

Perhaps the  most important characteristic of a particular investment is its expected return. Returns are normally positively correlated with risk so if an investor wants high returns it will normally come at the expense of taking on more risk. Risk in this case refers to not only the potential reduction in the income stream that the investment generates (if any) but also and more importantly to the potential loss of the original amount that was invested.

For example, a very safe investment in the USA is government debt. It is very unlikely that an investment backed by the federal government of the USA will either fail to make timely coupon payments or repayment of principal at the end of the investment’s life (this in financial terms is called a default). A 12-month treasury bill for example will generate a return on investment as of today of 0.33%. That means that if you invest $100 in a 12-month t-bill you will have received by the end of one year $0.33 (return) and then the original $100 that you invested. For some people this return is too little and they would like to get higher returns for the money that they will have to do without as long as it’s invested. If higher returns are desired, then the only solution possible is for the investor to take on more risk. For example, the investor can look at corporate bonds (which carry a higher default risk than government bonds) which would offer higher returns but with a higher risk (since corporations can actually default and declare bankruptcy for example).

At the riskiest end of the spectrum and therefore the one that offers the highest potential returns are equities since a stock price can easily appreciate or depreciate very rapidly and in moves of large magnitude.

Normally, the way an investor would go about selecting an investment would be to determine how comfortable he or she is with risk and then selecting an asset class that suits his or her risk tolerance. Once this is defined, usually the investor (or a portfolio manager) would look for a particular investment or investments as part of a diversified portfolio (i.e. the particular stocks, bonds, commodities, etc.) that are considered undervalued based on fundamental factors such as revenue growth, earnings potential, economic prospects, etc. and then buy them and hold them for as long as the reason behind their selection is still valid.

This means that investors normally plan to hold the financial instruments they acquire for the medium to long term and are somehow disinterested in their day to day (or minute by minute) fluctuation. For example, if an investor buys shares in a strong company he or she will hold those shares for as long as that premise remains valid regardless of what the stock price indicates on a daily basis.

The mechanics of actually acquiring the financial instruments (stocks, bonds, futures, options, forex, etc) are the same for investors and for traders and because of this, sometimes the line between investing and trading is not entirely clear. However, the reasoning behind investing and trading decisions are completely different.

We will look at the differences betwen investing and trading in a subsequent article.