Investment

economic-dictionary

An investment is an activity that consists of dedicating resources with the objective of obtaining a profit of any kind.

In economics, resources are usually identified as associated costs. The main resources are land, time, labor, and capital. With which, everything that is to make use of any of these four resources with the aim of obtaining a profit is an investment.

When an investment is made, an opportunity cost is assumed by giving up those resources in the present to achieve future benefits, which are uncertain. For this reason, when an investment is made, a certain risk is being assumed.

To have money to invest it is necessary to have had income and previously saved part of this income.

Investment types

The classification of investments can be done from different points of view. Thus, there is no single classification, nor one that is better. There are several, all valid and useful depending on the context.

According to the time horizon:

  • Short term: Less than 1 year.
  • Medium term: Between 1 and 3 years.
  • Long term: More than three years.

Depending on the element in which it is invested:

  • Machinery: Tractors, robots, packaging machines ...
  • Raw materials: Metals, food, fuel ...
  • Transport elements: Vans, trucks, cars ...
  • Buildings: Industrial warehouses, offices, commercial premises ...
  • Investment in shares of other companies
  • Investment in research and development (R&D).

According to the scope:

  • Business
  • Personal.
  • Financial

According to the nature of the subject:

  • Private
  • Public.

According to the adaptation to the recipient:

  • Personalized or made to measure.
  • Generalist or standard.

We could cite many more investment classifications, but the above are the essential ones. That is, the most important.

How does an investment work?

To know how an investment works, it is important to know the economic meaning of investment. Whatever its type, it is governed by four fundamental factors. Profitability, risk, liquidity and term. This is, what we gain, what we could lose and the time.

  • Profitability: Profitability or yield is what we get in exchange for making the investment. It is usually measured in terms of profit or profitability, although it does not have to be that way.
  • Risk: Refers to uncertainty. In economics, nothing is 100 percent certain. With which, we must always work with assumable risks in case the investment does not turn out as we expected.
  • Liquidity: It is the ability to convert a certain investment into money with minimal losses with respect to its value.
  • Term: Time is the third fundamental variable. We can expect a certain return, but depending on the time it takes to obtain it, will it pay off the investment or not?
See relationship between profitability, risk and liquidity

Taking care of these four factors, although it may seem obvious, is not so common. Many investors tend to focus on the first of the factors. Focusing on how much I will earn is not always a good idea. We must also pay close attention to the other two factors. And, especially, risk.

How do you know if one investment is better than another?

Knowing if an investment is better than another or others is something frankly difficult. In essence, it will depend on the preferences of each investor. Some will consider that a profitability of 50% is very good and others will settle for 10%.

More if possible, we must also take into account the aversion to risk and the patience or impatience of the investor (term).

That said, and taking into account that it is not about black and white, there are several methods to compare different investments monetarily. For instance:

  • Internal Rate of Return (IRR).
  • Pay-Back.
  • Net present value (NPV).
  • Discount of cash flows.
  • Profitability-risk ratios.
  • Valuation ratios: ROCE, ROE, ROI, PER or EPS.

There are other methods to compare, but these are the best known and most affordable. Using one or the other will depend, among other things, on the nature of the investments we make.

Difference between saving and investing

On the one hand, we call savings to the money that we keep to be able to dispose of it in the future. We renounce spending it in the present, putting it in a safe and risk-free place, but which usually generates interest. We are saving when we keep our money in cash, when we keep it in a bank account or when we keep it in a deposit, for example.

On the other hand, we call investment to that money that we give up spending in the present so that in the future it will provide us with extra money. We associate investing with the purchase of a good or financial asset, in the hope of making a profit. This extra profit that investment brings us with respect to saving is due to the fact that with the investment we are risking our money, and for this we receive compensation. We can invest our money in a myriad of things, from something immaterial like education to financial assets like stocks, bonds or mutual funds.

See full entry difference between saving and investment.

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