Investment definitions

The term investment can be used to describe any activity where money, time or effort is put into something to make a profit or gain an advantage.

From a financial perspective, this includes buying bonds, stocks, or property. However, non-financial investments can also be made such as committing to further education in the hope of increasing skills and knowledge to secure a better job, and therefore more money, in the future.

In this article, we explore how the term investment is used and what it can mean in different circumstances.

Investment definition

Different types of investment

There are three main types of investments, which can be invested in either directly or indirectly.

Stocks

If a company needs to raise money to start-up or grow, they may choose to sell shares of stock, which individuals or businesses can invest in. This makes the purchaser a shareholder. The two types of stock are:

  • Common stock
    Shareholders own a percentage of the company, are given the right to vote on matters impacting the company and may receive dividends.
     
  • Preferred stock
    Shareholders usually receive dividends at stated intervals of a predetermined amount but dont tend to have voting rights.

The level of returns and risks for each type of stock depend on many factors including the economic environment and how the company is performing.

Bonds

A bond is effectively a way of lending money to a company or governmental entity for an agreed period of time during which interest is paid to the bondholder. The amount received is reliant on the interest rate determined by the issuer of the bond. This is known as a coupon rate, which can either be fixed or variable. At the end of the agreed investment period, known as the maturity date, the issuer of the bond is obliged to repay the initial loan amount.

Due to the regular interest payments that the bondholder receives, bonds are considered a more secure investment compared to stocks. Although bonds are favoured for their stability, the long-term return that they generate tends to be lower than stocks.

Cash equivalent

Cash equivalent is the safest form of investment, which still allows the investor to have access to their money. Examples of cash equivalent investments include savings accounts, short-term government bonds, and certificates of deposit. Although investors can achieve a steady flow of income with cash equivalents, they arent intended for long-term investment goals, and minimal returns should be expected.

Investment banking definition

An investment bank provides an array of different services intended to help an individual or business increase their wealth through investment vehicles such as trading and asset management.

An investment bank performs two primary functions in the financial markets, which can often conflict. Traditionally, investment banking relates to advice given to big corporations that wish to float on the stock market, borrow money in the bond market or acquire another company. Just as a solicitor or accountant would provide impartial advice, an investment bank offers its expertise for a fee.

However, investment banks also deal directly in financial markets for their own account. Money is made by purchasing financial assets from one client and then selling them to another for a profit. Although these transactions are considered risk-free for banks the downfall of Lehman Brothers and other financial services firms prove that there are lots of risks in times of economic uncertainty.

Return on investment definition

Return on investment, also known as ROI, is a ratio applied to calculate the profitability of an investment as a percentage of the cost. Due to the simple formula, ROI is one of the most commonly used investment ratios used by both individual and corporate investors.

To calculate the return on investment, the net profit (or loss) is divided by the cost of the investment and then multiplied by 100. Usually, a positive ROI is viewed as a good move as it means that the investor has received back more than they initially invested.

It should be remembered though that the ROI calculation doesnt allow for the time value of money. Most investments have additional costs such as time and effort, which isnt reflected in the simple ROI formula. So while its a good indicator of whether an investment has been successful or not, it doesnt show the whole picture.

Capital investment definition

Simply put, capital investment is the money used to buy things in the market. Purchases of fixed assets like land, buildings, machinery and computer equipment are deemed to be capital investments as they can benefit business over a long period of time.

The general perception of capital investment is that the item or asset must be worth a considerable amount of money. But how much it originally cost bears no reflection on its current value to a business if it generates additional revenue.

Capital investment is not just buying things with money. As well as tangible items, capital investment can be intangible such as liquid assets or buying property for leasing purposes. Regardless of whether an investment is tangible or intangible, the main objective is generally the same, namely, growth, income and safety.

  • Growth
    Capital gains are realised when an item or asset purchased is sold at a higher price than its original cost. Similarly, capital loss occurs if items or assets are sold at a lower price.
  • Safety
    The type of investment influences how safe the capital investment is. Of course, no investment can be considered entirely risk free; some are safer than others. Investments such as government securities and corporate bonds can safeguard capital while providing a return at the same time.
     
  • Income
    If income is the primary objective, then safety has to be compromised. Increase in yields requires a certain degree of risk. Therefore, investment portfolios tend to be made up of income generators and safer options to balance the risk for investors.

Investors need to undertake thorough research and due diligence before making any investment. The effort spent researching different investment opportunities pays off in the long run.

Foreign direct investment definition

A foreign direct investment, also referred to as FDI, is an investment made by an individual or company in one country into business interests in another country. Foreign direct investment tends to occur when an investor purchases foreign business assets, which result in ownership or control of an international company. These differ from portfolio investments whereby an investor only buys equities of a foreign company.

Things to know before you invest

If youre considering investing to save for a rainy day, to provide funds for your retirement or to give your children the best possible start in life, then you should make sure that youre in a strong financial position. Follow these four steps:

1. Evaluate your situation

You should only invest if you can afford to do so. As a guide, you should ensure that you have access to a minimum of three months of normal expenditure before you look to invest. Its also worth paying off any loans or credit cards that generally have high-interest rates before investing. Finally, give some thought to what your financial situation may be in five or 10 years as well as how it is now as investing is a long-term commitment.

2. Know why youre investing

Set yourself a specific goal for your investment and then understand the timeframes needed to achieve your goal. This will help you to decide what types of investments are best for you.

3. Understand the risks

As well as making money from investments, you can also lose money, so its crucial that youre aware of the risks involved. Of course, some investments are riskier than others, but these tend to come with the highest rewards. If possible, spread your investment between a number of different shares that range from low risk to high returns. As investments are generally long-term, never invest with money that you may need to access at short notice.

4. Find the investment thats right for you

You dont always need a large lump sum to start investing, but you do need to understand that unlike cash, which is secure, investments carry risks as they can fall in value as well as rise.

Investing is a big decision, so you should always research to find the best option for you. If youre still uncertain of the suitability of an investment for your circumstances, then seek professional advice.