What is Investment?
Investment is the process of allocating capital to a financial instrument (e.g., stocks, bonds) backed by an expectation to receive certain benefits in the future. In the financial world, the benefit of investment is referred to as a return.
The return can be either positive (gain) or negative (loss). Returns can be in the form of proceeds from the sale of an investment, an investment income, such as rental income, dividends, interest income, or unrealized capital appreciation (or depreciation), etc.
The return may also involve currency gains or losses as a result of the foreign currency exchange rate fluctuations. So, when a company exchanges the proceeds from one of its foreign subsidiaries into the home currency for financial statements consolidation, it may record currency translation gains or losses based on the currency exchange rate at the time of the transaction.
- Investment is an activity of capital allocation so it can produce a return in the future.
- The higher the risk, the higher the return investors will require as compensation.
- There are two strategies of investing: value investing and growth investing.
The Golden Rule
The golden rule of investing is as follows:
“The higher the risk, the higher the return.”
In other words, the higher the risk, the higher the return an investor would claim as compensation for taking the risk. So, when a low-risk investment is made, the return is going to be low as well and vice versa.
The two main investing strategies are as follows:
1. Value investing
Value investing represents an investment into an asset (e.g., security) that is estimated to be currently undervalued. To conclude whether a security is undervalued or overvalued, an investor performs a comprehensive financial analysis by calculating all the essential metrics and accounting ratios, such as earnings per share (EPS), sales growth, P/E ratio, P/B ratio, etc.
In other words, value investors are focused on the current value of security without taking into account the potential future value growth of the security.
2. Growth investing
Growth investing is an investment aimed at increasing an investor’s capital in the future. Growth investors contribute capital to securities, such as stocks, that are expected to appreciate over the long term.
So, growth equity investors typically invest in young companies with high potential and whose earnings are expected to increase at an above-average rate compared to the overall industry.
Growth investing is enticing because, after investing in emerging companies for the long term, investors can receive substantial returns provided the company succeeds, and the value of the stocks increases significantly.
On the other hand, since emerging companies are new and untested, growth investing imposes a relatively high level of financial risk onto investors.
The five main factors a growth investor takes into account when evaluating stocks include:
- Historical growth of earnings per share (EPS)
- Future growth of the EPS
- Profit margins (Gross profit margin, net profit margin)
- Return on equity (ROE)
- Share price performance
Investment vs. Saving
Investing in a company with an unstable financial situation due to an economic crisis, for example, implies bearing the risk of a potential default of the company. Since the company is in financial distress, an investor would claim a higher interest rate to compensate for the level of risk.
If the company goes bankrupt, the investor will lose its invested capital, provided there is no option to claim it back from the company.
On the contrary, saving is simply an accumulation of money for future utilization. It is completely risk-free because capital is not employed, meaning it is just lying on a bank account.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
- Investing: A Beginner’s Guide
- Price to Sales Ratio
- Rate of Return
- Systematic Risk