When we are investing money it
means we are parting away our cash to someone for future incomes. There are
three ways when an investment gives us a money:
1. Giving
money as a Loan. In this case the loan giver or Lender gets some fixed interest
(some time variable interest also depending upon the terms and conditions) from
borrower and also his capital investment at the end of the tenure. Here
normally the returns are fixed.
2. Become
a partner in some business. Means buying shares of a business and receiving the
profit share on this business. We may get a handsome profit or nothing
depending upon the nature and performance of that business.
3. Buying
something whose value can appreciate in the future. Like Gold, Paintings, Land
etc.
Any
investments will be classified in these three terms either individually or
jointly with others. But the basics will remain within these three parameters.
- So when we are lending money means like buying bonds and making Bank Fixed Deposits there is fixed return from the investments and will not be dependent on the performance of borrowers business. No matter how successful that business may become, our returns will remain fixed as decided at the beginning.
- When we are buying shares means we are part owner of that business and accordingly bear the risk and reward of that business. If business does well we earn handsome dividend and may be the value of the business also goes up, however if its doing bad we have to bear the losses also. In this case the risks are high, and the potential of reward is also high.
- In the third kind of investments it’s purely the future price of that asset, if it goes up we earn profit and if it goes down we may lose money. Here the demand supply also plays a vital role on the value of these assets. Higher the demand and lesser the supply will lead to rise in value and vice-versa.
In investing jargon, the first
type (lending) is called debt, or fixed income investing. The second type
(owning) is called equity investing, with stock or shares being synonyms for
equity. The third one is called owning physical assets. Almost everything that we
invest in can be classified as one of these asset types. For example, bank
deposits or company deposits are debt while buying shares or investing in
equity mutual funds is equity. While buying gold would be called as owning
physical assets.
While there are a lot of ways in
which investments differ from each other, there are three basic characteristics
that define any investment:
Risk: The
likelihood of an investment not fetching the return we expect from it.
Returns: How
much returns does the investment fetch actually.
Liquidity:
Whether we can withdraw our money at any time.
Each of these three factors have
some nuances to them. To start with Returns, when someone invests money his
main objective is to get highest possible returns with minimal possible risk.
However, normally, higher returns come with higher risk. Again, the defining
example of this is the debt to equity comparison. Debt investments have less
risk and low returns but equity can have higher returns with higher risk. There
are huge variations within equity and it’s perfectly possible to have higher
risk as well as poor returns. In fact, that’s what most careless or
overconfident equity investors actually get.
Risk can be defined as the
likelihood of loss, or the likelihood of not getting the expected return.
Generally, debt has the lowest risk and equity the highest. However, there are
many variations to this idea. For example, debt investments in failing
businesses (Bank’s Loan to Vijay Mallya is the latest example) can be very
risky while on the other side there are many ways of managing risk levels in
equity.
Liquidity is about getting your
money back on demand. For example, if we keep our money in a savings bank
account, we can walk into any ATM anywhere in the world and immediately
withdraw it, subject to some limits. If we go into a bank, we can withdraw all
of it. In some investments, there could be a penalty for liquidity. In a fixed
deposit, either we have to wait for the whole term, or settle for less returns
or pay the penalty. In equity shares, liquidity varies from stock to stock. Big
Company’s shares could be bought or sold at any time for any amount however for
small companies it may not be that easy. For physical assets the liquidity and
value depends on demand and supply of that asset. For example the paintings of Leonardo
da Vinci will always fetch high price due to two factors one is the quality of
painting and secondly now the painter is no more so there is no further supply
of paintings from the creator and hence limited existing supply.
While deciding about the
investment we have to keep it in mind about these factors and may distribute the
portfolio among all of them so as to diversify the risk as well as get the
returns from all prospective options.
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