How to evaluate various Investment Options

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.