Concept of Investment
Man, it is said, lives on hope. But, hope is only a necessary condition for life, but not sufficient. There are many other materialistic things that he needs – food, clothing, shelter, etc. And, like his hope, his needs too keep changing through his life. To make things more uncertain, his ability to fulfill the needs too changes significantly. When his current ability (current income) to fulfill his needs exceeds his current needs (current expenditure), he saves the excess. The savings may be buried in the backyard, or hidden under a mattress. Or, he may feel that it is better to give up the current possession of these savings for a future larger amount of money that can be used for consumption in future.
In contrast to the above situation, if the amount available for current consumption is less than the current needs, he has to engage in negative saving, or borrowing. The funds thus borrowed may be used for current consumption. But, the lender of the money who forgoes his current possession and hence its consumption will ask for more than what he has lent. That is. the borrower should be willing to pay more than he has borrowed.
This trade off between the amount available for present consumption and future consumption is at the heart of all savings and investments. The ratio between the amount of current consumption that can be exchanged for a certain future consumption is called the pure or risk-free rate of interest or pure time value of money. This relationship is influenced by the forces of supply and demand and is determined in the capital markets. If foregoing 100$ of certain income today gives a certain income of 104$ after one year, the pure rate of exchange or pure rate of interest is said to be 4 percent.
The pure rate of interest referred to above is a real rate as it is based on two amounts of money that are fully certain. If the lender expects the purchasing power of money to fall during the time he lends money, he expects, in addition to the pure or risk-free rate, an amount to compensate him for the fall in the purchasing power of money. If the realization of the future amount is uncertain, he will expect much more and such excess is called the risk premium.
Keeping all the above in view, it can be said that an investment is an agreement for a current outflow of money for some period of time in anticipation of a future inflow that will compensate for the changes in the purchasing power of money, as well as the uncertainty relating to the inflow of the money in future. This understanding describes well all the possible investments, like stocks, bonds, commodities or real estate by all classes of investors like individuals, institutions, governments, etc. In all these investments, the trade off is between a known amount that is invested today, in return for an expected amount in future. While the amount being invested is certain, as it is now in our hands or rather is going out of our hands, the expected future inflow carries with it uncertainties regarding its realization and its real worth will be known only when it is due for realization.
Definition and Features of Investment
According to Fisher, investment may be defined as “a commitment of funds made in the expectation of some positive rate of return”. Expectation of return is an essential element of investment. Since the return is expected to be realized in future, there is a possibility that the return actually realized is lower than the return expected to be realized. This possibility of variation in the actual return is known as investment risk. Thus, every investment involves return and risk.
Investment is an activity that is engaged by people who have savings, i.e. investments are made from savings, or in other words, people invest their savings. But all savers are not investors. Investment is an activity which is different from saving. It means many things to many persons.
The following are the features of any Investments:
- Safety of Principal: The safety sought in investment is not absolute or complete; it rather implies protection against loss under reasonably likely conditions or variations. It calls for careful review of economic and industry trends before deciding types and/or timing of investments. Thus, it recognizes that errors are unavoidable for which extensive diversification is suggested as an antidote. Adequate diversification means assortment of investment commitments in different ways. Those who are not familiar with the aggressive-defensive approach nevertheless often carry out the theory of hedging against inflation-deflation. Diversification may be geographical, wherever possible, because regional or local storms, floods, droughts, etc. can cause extensive real estate damage. Vertical and horizontal diversification can also be opted for the same. Vertical diversification occurs when securities of various companies engaged in different phases of production from raw material to finished goods are held in the portfolio. On the other hand, horizontal diversification is the holding by an investor in various companies all of which carry on activity in the secure stage of production. Another way to diversify security is to classify them according to bonds and shares and reclassify according to types of bonds and types of share. Again, they can also be classified according to the issuers, according to the dividend or interest income dates, according to the products which are made by the firms represented by the securities. But over diversification is undesirable. By limiting investments to a few issues, the investor has an excellent opportunity to maintain knowledge of the circumstances in accordance with each issue. Probably the simplest and most effective diversification is accomplished by holding different media at the same time having reasonable concentration in each.
- Adequate liquidity and collateral value: An investment is a liquid asset if it can be converted into cash without delay at full market value in any quantity. For an investment to be liquid it must be reversible or marketable. Reversibility is the process whereby the transaction is reversed or terminated while marketability involves the sale of the investment in the market for cash. To meet emergencies, every investor must have a sound portfolio to be sure of the additional funds which may be needed for the business opportunities. Whether money can be raised by sale or by borrowing, it will be easier if portfolio contains a planned proportion of high-grade and readily saleable investment.
- Stability of income: An investor must consider stability of monetary income and stability of purchasing power of income. However, emphasis upon income stability may not always be consistent with other investment principles. If monetary income stability is stressed, capital growth and diversification will be limited.
- Capital growth: Capital appreciation has today become an important principle. Recognizing the connection between corporation and industry growth and very large capital appreciation, investors and their advisers constantly are seeking growth stocks. It is exceedingly difficult to make a successful choice. The ideal growth stock is the right issue in the right industry, bought at the right time.
- Tax Benefits: To plan an investment programme without regard to one‘s tax status may be costly to the investor. There are really two problems involved here, one concerned with the amount of income paid by the investment and the other with the burden of income tax upon that income. When investors income is small, they are anxious to have maximum cash returns on their investment, and are prone to take excessive risk. On the other hand, investors who are not pressed for cash income often find that income tax deplete certain types of investment income less than others, thus affecting their choices.
- Purchasing power stability: Since an investment nearly always involves the commitment of current funds with the objective of receiving greater amounts of future funds, the purchasing power of the future fund should be considered by the investor. For maintaining purchasing power stability, investors should carefully study: the degree of price level inflation they expect, the possibilities of gain and loss in the investment available to them, and the limitations imposed by personal and family consideration.
- Concealability: To be safe from social disorder, government confiscation or unacceptable levels of taxation, property must be concealable and leave no record of income received from its use or sale. Gold and precious stones have long been esteemed for these purposes because they combine high value with small bulk and are readily transferable.
Perceptions of Investment
Investment has got three perceptions:
- Financial Perception: Investment is the allocation of monetary resources to assets that are expected to yield some gain or positive return over a given period of time. These assets range from safe investments to risky investments. Investments in this form are also called as €•financial investments.
- Economic Perception: To the economists Investment means the net additions to the economy‘s capital stock which consist of goods and services that are used in the production of other goods and services. In this context, the term investment, therefore, implies the formation of new and productive capital in the form of new construction, new producer‘s durable equipment such as plant and equipment.
- Social Perception: An investment made to ensure communal harmony and social benefit such as investment in polio campaign, etc.
Are all Investments Speculative?
We know that investment means sacrificing or committing some money today in anticipation of a financial return later. The investor indulges in a bit of speculation as to how much return he is likely to realize. There is an element of speculation involved in all investment decisions. It does not follow though that all investments are speculative by nature.
Genuine investments are carefully thought out decisions. They involve only calculated risks. The expected return is consistent with the underlying risk of the investment. A genuine investor is risk averse and usually has a long-term perspective in mind. Each person seems to have made carefully thought out decision and each has taken only a calculated risk.
Speculative investments on the other hand are not carefully thought out decisions. They are based on rumors, hot tips, inside dopes and often simply on hunches. The risk assumed is disproportionate to the return expected from speculation. The intention is to profit from short-term market fluctuations. In other words, a speculator is relatively less risk averse and has a short-term perspective for investment.
So, an investment can be distinguished from speculation by (a) the time horizon of the investor and (b) the risk-return characteristics of the investments. A genuine investor is interested in a good rate of return, earned on a rather consistent basis for a relatively long period of time. The speculator, on the other hand, seeks opportunities promising very large returns, earned rather quickly. In this process, he assumes a risk that is disproportionate to the anticipated return.
There exists a clear-cut demarcation between investment stocks and speculative stocks. The same stock can be purchased as a speculation or as investment, depending on the motive of the purchaser. For example, the decision of an investor to invest in a stock is considered as a genuine investment, if he seems to be interested in a regular dividend income and prospects of long-term capital appreciation. However, if another investor buys the same stock with the anticipation that the share price is likely to raise very quickly and gain from the rise, such decision will be characterized as speculation.
Are Investment and Gambling the Same?
Gambling is defined as an act of betting on an uncertain outcome. Since the prospective return on investment is uncertain at the time investment is made, one may say that there is an element of gambling involved in every investment. This is particularly so in the case of those investments in respect of which little information exists at the time of investment decision. However, genuine investments cannot be labelled as gambling activities.
In gambling, the outcome is largely a matter of luck; no rational economic reason can be given for it. This is in contrast to what we can say about genuine investments. Unlike investors and speculators, the gamblers are risk lovers in the sense that the risk they assume is quite disproportionate to the expected reward. Though the pay-off, if won, is extraordinary, the chances of winning the bet are so slim that no risk averse individual would be willing to take the associated risk.
It should, however, be noted that a clear demarcation between investment, speculation, and gambling is not always easy. Often it becomes a matter of degree and opinion. Aggressive investors are likely to decide on investments based, among other things, on their speculative and gambling instincts more than the defensive or conservative investors do.