As the first step on the path of learning about investments, one must answer the fundamental question: What is an investment?
Surprisingly, a lot of people are actually confusing investment with speculation or even gambling.
The Merriam-Webster dictionary defines an “investment” as follows:
“the outlay of money usually for income or profit”
This definition however lacks one crucial ingredient. An investment should have a reasonable chance of returning both the principal (i.e. money originally invested) and the profit. If an opportunity does not provide a reasonable chance of returning both the principal and the profit, then it is not an investment. This is an extremely important point to understand and in my mind it represents the core of what a true investment is.
When one makes an investment, one forgoes immediate consumption in exchange for future consumption. This delay in consumption must be compensated by profit. For example, let’s say you have $1,000 right now. You could spend this money today and get the benefit of goods and/or services that this money can buy. Alternatively, you could invest it, thus delaying your ability to enjoy your money into some future point in time. If in the future, all you got back was your original amount then it would not make sense for you to invest it, as you would not be gaining anything. In fact, you would probably be losing money since your $1,000 in the future would be worth less due to inflation (i.e. it would buy less goods/services). Therefore a true investment must not only return your original amount that you have invested, but also profit as a compensation for using your money. Not only that, but to be worthwhile (assuming your principal was after tax) the profit after paying taxes should be higher than inflation over the period during which your money was invested.
You will notice that in my definition of an investment, I referred to a “reasonable chance” of returning both principal and profit. What is a “reasonable chance”? Interestingly enough that depends on an individual investor. Every single investment entails “risk”. Risk is the lack of certainty regarding how much principal and profit you will get back. History has shown us that even the highest rated securities issued by governments are not free of risk. Therefore it is up to each individual person to decide what their comfort level for taking investment risk is. The riskier the investment, the less certainty there is regarding the outcome. If an investor is knowledgeable and has done their due diligence, they would demand a higher profit for riskier investments. Unfortunately in the real markets this is not necessarily the case. There are many investors who own risky investments which do not necessarily pay bigger profits than the available alternatives.
Let’s look at some examples of investments and speculation/gambling according to our definition:
- Is buying a lottery ticket an “investment”? Absolutely not! Since the chance of winning a lottery is exceedingly small, you cannot have any reasonable expectation of receiving back your original amount plus profit. Hence it is nothing but a gamble.
- Is buying a stock about which you know nothing about an “investment”? No, since you know nothing about the particular stock, you have no reasonable expectation of receiving back your principal and profit. This would be gambling rather than investing.
- Is buying a stock below its intrinsic value an “investment”? Yes, provided you have done your due diligence and can reasonably expect the stock price to return to its intrinsic value within some limited time frame, you have a reasonable chance (but not guaranteed) of getting back your invested amount with a profit at the end of the period. This would be considered an investment.
Hopefully this article helps you think about investment opportunities in a different light. You should always be asking yourself the questions:
- Can I reasonably expect to get back my invested amount with a profit?
- What is the chance that I will not get back part or all of the invested amount and profit?
- Am I comfortable with these chances?
If you’ve answered “No” to any of these questions, it is a good indication that this investment opportunity is probably not for you.