Investment denotes a sacrifice of an individual’s resources today for expectations of gaining more resources in the future. Individuals can either consume, save or invest their money. They choose the investment option due to a number of reasons, all founded on the expectation of deriving more economic benefits over and above the other options. Prudent investments follow a well-defined procedure and investors have many investment alternatives, for example, real assets and financial products such as stocks and bonds.
Definition of Investment
In a broad perspective, investment is defined as the sacrifice of money and other resources today with expectations of making more money or wealth in the future. A typical illustration of an investment from this definition is enrollment to college. An individual can choose to go to school whereas they are many other things they can do with their money and time. But they choose to go to college because they have some expectations for worthy benefits in the future, after graduating. These future benefits could be in the form high salary and high living standards.
Investment from the above definition entails a number of significant elements. First, resources are scarce and thus valuable. Thus, investment deals with prudent management of one’s money today in hope of receiving returns or more money in the future. Secondly, since the expected returns on investments are in the future, investment involves uncertainty and risk, that is, there is no guarantee that the expected benefits or returns on investments will be realized. However, prudent financial management recommends investing to other alternative uses of money despite the inherent uncertainty and risk due to the fundamental concept of opportunity cost of cash. By not investing, the prospective benefits, for instance, in the form of increase in value of asset are foregone. Therefore, individuals find it important to invest in order to evade the opportunity cost of money.
Investment can also be defined as an asset that is bought with the expectations that it will yield more income or appreciate in value in the future. The asset could be a real asset, such as rental property or securities, for example, bonds, stocks, and real estate investment trusts.
Why Should People Invest?
People should invest for the basic reason of achieving financial security. For majority people, investing over long periods of time is the sole way to gain financial security. Financial security is attained in number ways. First, investing means that money is enabled to earn more money. For example, a bond contract requires that the investor receives periodical interest income and receive back the principal amount at the stipulated maturity date. Similarly, investing in a company’s stocks confers the right to become a shareholder in the company and regular earnings in the form dividends. The stock or any other asset can be disposed upon appreciation of price for capital gains. Financial security in turn empowers individuals to attain personal goals.
How to Invest
Prudent investment involves a number of steps that are implemented in a consistent manner. The Securities and Exchange Commission outlines a three-step guideline to sound investing- asset allocation, diversification and rebalancing.
Asset allocation involves assigning investment money among distinct categories of assets. The process of determining the appropriate portfolio of assets should be guided by two factors, time horizon and individual’s ability to tolerate risk. Time horizon refers to the expected duration an investment is made to achieve a certain objective. Individuals with stretched time horizons are more probable to be contented with placing money on riskier investments since they can be bear slow economic cycles and the inevitable market fluctuations. On the other hand, individuals saving up for college education are more probable to take less risky and less volatile investments, due to the short time horizons.
Risk tolerance refers to the individual’s capacity and willingness to bear loss of the original investment in exchange for higher potential returns. An investor with high tolerance to risk is more likely to engage in high risk investments with an aim of getting high returns.
By contrast, investors with low tolerance to risk are likely to prefer investments that can preserve the value of their wealth.
Diversification refers to the process of distributing resources through a number of investments so that if one investment fails, the other investments can offset the loss. Diversification of an investment portfolio should be done in two levels- between and within categories of assets. Diversification between asset categories is achieved in the allocation stage where investment money is apportioned to different types of assets such as stocks and bonds, real estate investment trusts, and mutual funds. The key objective of diversification from this dimension is to identify categories of assets that are bound to performance differently under different market conditions. Diversification can be done within asset categories by investing in a wide range of carefully selected firms and industry sectors.
Rebalancing is the process of bringing a portfolio back to the original asset allocation mix. Rebalancing is warranted since over time, some investments may lose alignment with an individual’s investment goals, for example, some investments may appreciate faster than others. Rebalancing ensures that no asset categories are overemphasized, and also returns the portfolio to the preferred level of risk. Rebalancing is done in three ways: 1) Investments can be sold off from over-weighted categories of assets and the proceeds used to buy investments in under-weighted categories of assets, 2) New investments can be bought for under-weighted categories of assets, and 3) If continuous contributions are made to the portfolio, the contributions can be altered so that more investments are made on the underweighted categories of assets until balance in the portfolio is achieved.
How to Buy Stock
Stocks are usually purchased through brokerage firms. The prospective investor should create a trading account by depositing money in a brokerage account. A number of firms like Citigroup’s Smith Barney provide brokerage accounts that can be operated online or with a broker in person. Once the brokerage account is opened, the investor should issue guidelines to the broker on the desired stocks, and the type of order, that is market order or limit order. A market order is one in which a stock is purchased at the market price. A limit order is one in which the broker is instructed to buy the chosen stock at a stipulated price. The broker implements the trade behalf of the investor. In turn, the broker earns a commission, usually a small percentage of the share price.
In summary, investment refers to sacrifice of resources today for expectations of gaining more resources in the future. Investment options include stocks, bond and mutual funds. The main goal for investing is to achieve financial security in the future through the current income or capital gains derived from the investments. A typical investment process involves three steps, asset allocation, diversification and rebalancing. Stock purchase can be made by opening a trading account with a brokerage firm, depositing money into the account and placing the preferred type of purchase order.