Investment is the use of savings to produce future income. The term more specifically refers to the use of funds to acquire capital goods, which are items that are necessary to produce other goods and services. Examples of capital goods include factories, offices, machinery, and computers.
Many people invest part of their current income to consume more in the future. Some do this by letting others invest their funds, while others invest directly in their own businesses.
Investment is vital for economic development and growth. When people deposit funds in bank accounts, for example, banks lend some of those funds to business firms. The firms, in turn, use these bank loans to invest in new buildings and equipment to expand production. Many firms also raise funds for business expansion by issuing stocks and bonds that are sold to investors. Governments also issue bonds to obtain funds to invest in such projects as dams, roads, airports, and schools.
All types of investments by individuals, businesses, and governments involve giving up present consumption of goods and services to provide for even greater consumption in the future. In this way, investment enhances a nation’s ability to produce goods and services and thereby increases its standard of living.
Kinds of investments
There are two main kinds of investments: (1) direct investments and (2) indirect investments. Direct investments involve purchasing physical goods, such as a piece of real estate or a business. Indirect investments involve purchasing financial assets, such as stocks and bonds. Money invested in a savings account is also considered an indirect investment.
Before making any investment, people should learn as much as possible about how the money they are investing will be used. People should also assess what the expected return will be from an investment. Because every investment entails risk (the possibility of loss), investors should carefully examine the expected return in relation to the risk involved. Some investments promise high returns but offer little safety. Others promise lower returns but provide almost complete safety. A person should also consider whether an investment can be liquidated (easily converted into cash) if an unexpected expense arises.
People should consider many types of investments, such as stocks and bonds, only if they are willing to incur the risk of losses. They should also have enough secure savings to protect themselves against any temporary loss of income resulting from illness or unemployment.
Direct investments.
Examples of direct investments are business investments and real estate investments.
Business investments.
Buying a small business may be the most demanding kind of investment. Investors may be required to work hard to earn an acceptable return. For this reason, the investor must be sure to choose the right business before making a commitment. If a person buys or opens a restaurant, for example, he or she may need to work long hours to operate it profitably.
Real estate.
People invest in real estate when they buy homes, land, or rental properties. Real estate may increase in value over time and thus be sold for a profit. Real estate may also produce income directly, in the form of rent, or indirectly, in the form of crops, minerals, or timber.
During some periods, real estate may produce a higher rate of return than many other kinds of investments. Real estate is an especially good investment during periods of inflation, when property values tend to rise along with other prices. But real estate prices can fall sharply during times of recession or depression.
Investing in real estate has some major drawbacks. It typically requires a large payment at the beginning of the investment period. For most individuals, the cost of a home is several times the buyer’s yearly income. Many families borrow a large portion of the purchase price of a home from a bank. Most business owners finance purchases of stores and other commercial property through a bank, pension fund, or insurance company.
Another drawback to real estate investment is that reselling property may take a considerable amount of time. In other words, such investments are low in liquidity—that is, the ease with which an investment can be turned into cash without loss.
Indirect investments
involve stocks and bonds and funds that flow through financial institutions in such forms as savings accounts.
Savings accounts
are a common kind of investment. Funds deposited in a savings account at a bank, credit union, or savings institution earn interest at a specified annual rate.
Most banks offer money market accounts, certificates of deposit (CD’s), and other special savings plans. Money market accounts pay a rate of interest that reflects conditions in the money market, where short-term government and corporate securities are traded. A security is an investment that can be bought and sold in a financial market. Securities include stocks, bonds, and options. Stocks are secured (backed) by ownership in a company. Bonds are secured by the promise of a borrower to pay a debt in the future. Options represent a choice to buy or sell something at a future date. Funds deposited in a certificate of deposit cannot be withdrawn without penalty for a specified period, such as one or two years. Money market accounts and CD’s typically pay a higher rate of interest than do regular savings accounts.
Most banks and savings institutions are privately owned and operated for a profit. Credit unions, in contrast, are not-for-profit cooperative organizations operated for the benefit of members and therefore do not, for the most part, pay taxes. All net earnings (earnings minus expenses) are passed on to members in the form of lower loan costs or higher returns on deposits.
Some types of savings accounts yield lower rates of interest than other types of investments. Nevertheless, they attract investors with low incomes or little investment experience because they involve minimal risk.
Bonds
include government securities and corporate bonds. Government securities are issued by federal, state, and local governments. These investments pay interest at a specified rate over a certain period.
Savings bonds issued by the United States government are popular among investors because they are sold in small denominations and are safe. Most savings bonds can be redeemed for cash, if necessary, after one year and pay fixed interest rates.
People investing at least $100 can buy other types of United States government bonds, including Treasury bonds. These bonds are traded on stock exchanges and typically pay a higher rate of interest than savings bonds. Some of these bonds pay a fixed rate of interest. If prices were to rise unexpectedly, however, the purchasing power of these bonds would also fall.
In 1998, the U.S. Treasury began issuing inflation-indexed bonds, also called I bonds. These bonds protect bondholders from being repaid in dollars whose value has been reduced by inflation. The bonds adjust the amount investors receive to correspond to current market prices. Many other countries also offer inflation-indexed bonds, including Canada, the United Kingdom, and Israel.
The U.S. government also sells securities called Treasury bills (T-bills). The minimum purchase for T-bills is $100. T-bills mature in periods of 4, 8, 13, 17, 26, and 52 weeks, much sooner than bonds do.
State and local governments issue securities called municipal bonds. The interest earned on these bonds is generally not subject to federal income tax. Municipal bonds therefore make attractive investments for individuals at upper income levels, who are taxed at high rates. Because of the demand created by this tax-free interest feature, such bonds typically pay lower interest rates than most federal bonds. The tax-free interest feature is limited on some municipal bonds, however, including those issued to pay for new sports facilities.
Corporate bonds represent loans made to business firms by investors. A firm pays its bondholders interest every year until the bonds mature. At that time, the firm redeems the bonds by paying bondholders their face value. In most cases, this amount is $1,000 per bond. If a firm defaults (fails to meet its financial obligations), the bondholders have the legal right to take over the firm and sell any assets pledged as security on the bonds.
The prices of bonds issued by corporations or by governments may change due to fluctuations in market interest rates. As a result, investors may fail to get back the full purchase price of their bonds if they sell them before maturity. In addition, investors may suffer losses if business firms or governments default.
Stocks
include two types of corporate securities: (1) common stock and (2) preferred stock.
Common stock
represents shares of ownership in a company. The stockholders of a firm share in its profits. They also share in the losses, but only to the extent of their investment. If a business firm has a profitable year, the stockholders may receive cash dividends. The exact rate of return on any common stock depends on its dividend and the price at which it trades in the market. If a firm suffers financial losses during a year, it may not pay a dividend, and its stock price may even decline.
A company may also decide to use its profits to expand its operations rather than to pay dividends. Some stockholders may not object to such a strategy as long as the firm’s stock price rises. Appreciation (increase in the value) of a stock represents a capital gain. Capital gains are the profits earned from the sale of stocks, real estate, or other income-producing property.
Preferred stock
is a type of corporate security that has features of both bonds and common stock. Like corporate bonds, preferred stock promises a fixed rate of return. The corporation must pay this return before it distributes any dividends to investors in common stock. Thus, preferred-stock holders face less risk than common-stock holders. Unlike bond owners, however, preferred-stock holders have no legal right to force a corporation to pay them the promised annual returns if the firm has insufficient earnings to do so.
Both common and preferred stocks can yield higher returns than bonds. Over long periods, the return on stocks has consistently exceeded the return on bonds and other types of investments. Stocks are riskier than bonds, however. As a result, investors cannot be sure that stocks will always outperform bonds. Also, the prices of individual stocks change constantly and often by large amounts. An economic slump or poor earnings at a particular firm can produce an unfavorable market reaction in all stock prices or in an individual stock price. For this reason, many individuals make an effort to buy both stocks and bonds.
Other kinds of indirect investments
provided by financial institutions include mutual funds and life insurance policies.
Mutual funds
are companies that invest in a variety of securities and sell shares in those securities to all types of investors. They offer some advantages to individual investors. For example, mutual funds employ specialists who select specific stocks or bonds that they consider most likely to meet the goals of a fund, such as capital appreciation or low risk. Mutual funds also permit investors to own securities in a large number and wide variety of business firms. This concept is called diversification. Diversification can reduce the overall risk of loss to investors because losses incurred by one firm may be offset by profits earned by another.
The cash dividends that mutual funds pay to their shareholders are generally taxable. Shareholders may automatically reinvest these dividends in additional shares of the mutual fund.
Mutual funds are also called open-end funds because investors in this type of fund can buy or sell shares whenever they wish. Mutual funds must buy back their shares for their approximate net asset value. This amount reflects the current market value of all the securities or assets of the fund. A closed-end fund is similar to a mutual fund, but it has a fixed number of shares that are bought and sold on stock exchanges, usually at a price below the net asset value.
Some mutual funds are called money market funds and invest only in government and corporate short-term securities. These funds provide an alternative to the savings accounts offered by banks. Money market funds usually pay higher rates of interest than bank savings accounts because they operate without all the expenses of traditional banks. Most money market funds, moreover, allow investors to write checks against their investment in the funds. Because money market funds only make short-term investments, there is relatively little variation in net asset value (NAV). As a result, such funds are highly liquid.
Life insurance policies.
Life insurance companies sell insurance policies that also act as a savings account. A person typically buys life insurance to provide financial protection for family members in the event of death. Many types of life insurance, however, include a savings provision. An insurance company sets aside part of each premium (insurance payment) paid after a policy has been in force for a certain period. This amount, called the cash value of the policy, accumulates and earns a specified rate of interest. In this way, it resembles a savings account.
The cash value of an insurance policy may be particularly useful in an emergency involving an unplanned expense. Policyholders can terminate their life insurance for the cash value or keep the policy and borrow against its cash value.
How investors buy stocks
Many people who buy stocks place their order with a brokerage company. A broker may fill the order by purchasing the desired shares from dealers or investment banks that sell newly issued securities. The broker may also relay the purchase order to a representative at a stock exchange where stocks are traded. The representative then carries out the requested transaction. The investor pays the purchase price of the shares, plus a commission for the broker’s services. Brokers also sell stocks for investors.
In the late 1990’s and early 2000’s, many investors began buying and selling stocks electronically, a method of investing called online investing. Online investing, which is also called electronic trading or e-trading, became more common as the internet began to grow in popularity. Individuals who invest online have more control over their investments than do people who invest through traditional brokers. They can access their brokerage accounts virtually anytime and from anywhere in the world. Most online brokerage services charge lower commissions than traditional brokerage firms charge. The online services can operate more cheaply because they have eliminated many expenses, such as a large staff and office space.
