In our last post, we discussed the role of investments in a complete financial strategy. But what is an investment? How does it work? And, what are the different types of investments you might include in your portfolio? We’ll answer these questions today.
What is an Investment?
Dictionary.com defines investment as something you put your money or capital into in order to gain profitable returns. Basically, when you invest, you buy something with the goal of making a profit.
How Investments Work
An investment can yield two different kinds of returns—income and capital gains.
Income is the regular cash flow your investment produces.
Capital gains is your investment’s increase in value over time. Capital, when referring to financial investments, means money. So a capital gain is a gain (or increase) in your money (which is the amount you invested). Of course, you can also experience a capital loss, which is a loss of some or all of your invested money. That’s the risk of investing.
For simplicity, let’s say you decided to invest in an apple orchard. To start, you might buy a young apple tree. How would this apple tree produce income and capital gains?
The tree would likely produce apples each year which you would then harvest and sell for income—annual cash flow you receive while keeping the tree.
As the years go by, hopefully your apple tree itself will grow; and as it grows, it’ll increase in value. In the future, you might sell the tree for a profit. The profit you make when you sell an asset (in this case the tree) at an increased value, is your capital gains.
Of course, as mentioned before, when you buy an asset like an apple tree (or a stock, bond, real estate, etc.), you take the chance that it might decrease in value, and you could lose money. If the tree produced no apples, then you wouldn’t have any income. If the tree were diseased and died, then you could lose your initial investment, the money you put into it—that’s a capital loss.
Because of the risk of a capital loss, it’s important to understand the different risks you take when you make an investment. We’ll dive deeper into various investment risks in our next blog post.
Let’s take a look at three assets that are common investments—stocks, bonds, and real estate.
What is a Stock?
A stock (also called equity) is ownership in a company. Similarly to buying an apple tree, when you buy a share of stock, you are buying an asset, in this case ownership in a company. For example, if you buy one share of Nike’s stock, then you are a shareholder and have a small ownership stake in Nike.
If the company whose stock you hold is successful and produces extra cash flow, it might decide to share that profit with its shareholders, including you, in the form of dividends. Dividends are the income paid to owners (shareholders) in a company. Not all companies pay dividends. Sometimes, they decide to reinvest their profits to fuel growth, so if you’re looking for a dividend payout, be sure that you’re investing in a company that pays dividends.
If the company is successful over the years, the value of the actual company will probably increase, and you can make a capital gain by selling your share at a higher price than you bought it. Just like the apple tree growing bigger and gaining value over time, if the company gains value, and you sell your share, then you have profited from capital gains. When you sell your share, you no longer own the company and can’t benefit from future dividends or growth. If you decide to invest in a company, you should research it’s overall health and future prospects.
What is a Bond?
Sometimes companies raise money by borrowing. Governments also borrow money for projects. When you invest in a bond, you lend money to a company or government and expect them to pay you back, over time, with interest.
For example let’s say you bought a 3-year bond from Nike for $10,000 at 5% interest. This means that Nike will borrow $10,000 from you today, pay you 5% interest (which is $500) each year for 3 years, and then repay the $10,000 at the end of the 3 years. The interest you earn is income.
If you hold the bond for the full 3 years, you expect to be repaid the amount you lent. But, you can also resell your bond early. If it’s worth more when you sell it, you make a capital gain. Let’s say you are holding the 5% bond from Nike, and interest rates in general go down. Someone else can now only purchase a 3% bond from Nike. That person might be willing to pay you a little more than $10,000 for your higher paying bond so they can take advantage of the higher interest rate.
The reverse is true, too. If interest rates go up to 7%, then you’d likely have to sell your bond at a loss if you wanted to cash out before it matured in 3 years. Also, if Nike’s credit rating decreased, and you wanted to resell your bond, it’s possible you would have to sell at a capital loss.
You could always hold the bond until it matures and receive your initial investment back assuming Nike is able to repay you. Many factors can affect the value of the bond you hold.
What is Real Estate?
There are different ways to purchase real estate as an investment, but for our purposes, we’ll assume that you buy a building, like a house, to rent out. Renting a portion of a home on a site like AirBNB has been a popular way to invest in real estate as well. Real estate, is most like our apple tree example in terms of income and capital gains.
When you lease your property to a tenant, they pay you rent, which is the income this investment produces. Over time, hopefully the value of the property increases. If you sell the property at a higher price, then you’ve made a profit in the form of a capital gain. If you sell at a loss, then you’ve incurred a capital loss.
A Word About Cash and Cryptocurrency
We’ve discussed the most common investments. Not all investments produce both income and capital gains (or losses). For example, cash is technically an investment. When you put your cash into a savings account, you expect interest in return. It’s a very small amount of income, and over time, likely doesn’t keep up with inflation, but it is income. The value of the actual dollars will not change over time, so you won’t experience capital gains or losses. This is why cash is a safe place to build a short-term emergency fund.
Cryptocurrency has become a popular investment in the past several years. Cryptocurrencies experience increases and decreases in value, and sometimes quite rapidly, so they do offer the potential for capital gains and losses. This volatility makes them more risky than other common investments. However, cryptocurrency doesn’t produce a regular cash flow and therefore doesn’t provide income. Gold, silver, and other precious metals similarly change in value, but don’t offer income.
Summing it Up
Today, we discussed different types of investments and how they produce income and capital gains (or losses). Each type of investment offers different risks and rewards, so it’s important to invest in assets that you understand and best suit your needs. This article is not meant to provide investment advice, and an investment advisor can best guide you in your specific needs. Check back in for our next article on balancing the risks that come with investing.