Investment
To invest is to allocate money (or sometimes another resource, such as time) in the expectation of some benefit in the future.
In finance, the expected future benefit from investment is a return. The return may consist of capital gain and/or investment income, including dividends, interest, rental income etc.
Investment generally results in acquiring an asset, also called an investment. If the asset is available at a price worth investing, it is normally expected either to generate income, or to appreciate in value, so that it can be sold at a higher price (or both).
Investors generally expect higher returns from riskier investments. Financial assets range from low-risk, low-return investments, such as high-grade government bonds, to those with higher risk and higher expected commensurate reward, such as emerging markets stock investments.
Investors, particularly novices, are often advised to adopt an investment strategy and diversify their portfolio. Diversification has the statistical effect of reducing overall risk.
Related terms
Investment differs from arbitrage, in which profit is generated without investing capital or bearing risk.
An investor may bear a risk of loss of some or all of their capital invested, whereas in saving (such as in a bank deposit) the risk of loss in nominal value is normally remote. (Note that if the currency of a savings account differs from the account holder's home currency, then there is the risk that the exchange rate between the two currencies will move unfavorably, so that the value in the account holder's home currency of the savings account decreases.)
Speculation involves a level of risk which is greater than most investors would generally consider justified by the expected return. An alternative characterization of speculation is its short-term, opportunistic nature.
Famous investors
Investors famous for their success include Warren Buffett. In March 2013 Forbes magazine, Warren Buffett ranked number 2 in their Forbes 400 list.[3] Buffett has advised in numerous articles and interviews that a good investment strategy is long term and choosing the right assets to invest in requires due diligence.
Edward O. Thorp was a highly successful hedge fund manager in the 1970s and 1980s who spoke of a similar approach.
The investment principles of both of these investors have points in common with the Kelly criterion for money management. Numerous interactive calculators which use the Kelly criterion can be found online.
Intermediaries and collective investments
Investments are often made indirectly through intermediary financial institutions. These intermediaries include pension funds, banks, brokers, and insurance companies. They may pool money received from a number of individual end investors into funds such as investment trusts, unit trusts, SICAVs etc. to make large scale investments. Each individual investor holds an indirect or direct claim on the assets purchased, subject to charges levied by the intermediary, which may be large and varied.
Approaches to investment sometimes referred to in marketing of collective investments include dollar cost averaging and market timing.
History
The Code of Hammurabi (around 1700 BC) provided a legal framework for investment, establishing a means for the pledge of collateral by codifying debtor and creditor rights in regard to pledged land. Punishments for breaking financial obligations were not as severe as those for crimes involving injury or death.
In the early 1900s purchasers of stocks, bonds, and other securities were described in media, academia, and commerce as speculators. By the 1950s, the term investment had come to denote the more conservative end of the securities spectrum, while speculation was applied by financial brokers and their advertising agencies to higher risk securities much in vogue at that time. Since the last half of the 20th century, the terms speculation and speculator have specifically referred to higher risk ventures.
value investing
A value investor buys undervalued securities (and sells overvalued ones). To identify undervalued securities, a value investor uses analysis of the financial reports of the issuer to evaluate the security. Value investors employ accounting ratios, such as earnings per share and sales growth, to identify securities trading at prices below their worth.
Warren Buffett and Benjamin Graham are notable examples of value investors. Graham and Dodd's seminal work Security Analysis was written in the wake of the Wall Street Crash of 1929.
The price to earnings ratio (P/E), or earnings multiple, is a particularly significant and recognized fundamental ratio, with a function of dividing the share price of stock, by its earnings per share. This will provide the value representing the sum investors are prepared to expend for each dollar of company earnings. This ratio is an important aspect, due to its capacity as measurement for the comparison of valuations of various companies. A stock with a lower P/E ratio will cost less per share, than one with a higher P/E, taking into account the same level of financial performance; therefore, it essentially means a low P/E is the preferred option.
An instance, in which the price to earnings ratio has a lesser significance, is when companies in different industries are compared. An example; although, it is reasonable for a telecommunications stock to show a P/E in the low teens; in the case of hi-tech stock, a P/E in the 40s range, is not unusual. When making comparisons the P/E ratio can give you a refined view of a particular stock valuation.
For investors paying for each dollar of a company's earnings, the P/E ratio is a significant indicator, but the price-to-book ratio (P/B) is also a reliable indication of how much investors are willing to spend on each dollar of company assets. In the process of the P/B ratio, the share price of a stock is divided by its net assets; any intangibles, such as goodwill, are not taken into account. It is a crucial factor of the price-to-book ratio, due to it indicating the actual payment for tangible assets and not the more difficult valuation, of intangibles. Accordingly, the P/B could be considered a comparatively, conservative metric.
Free cash flow and capital structure
Free cash flow measures the cash a company generates which is available to its debt and equity investors, after allowing for reinvestment in working capital and capital expenditure. High and rising free cash flow therefore tend to make a company more attractive to investors.
The debt-to-equity ratio is an indicator of capital structure. A high proportion of debt, reflected in a high debt-to-equity ratio, tends to make a company's earnings, free cash flow, and ultimately the returns to its investors, more risky or volatile. Investors compare a company's debt-to-equity ratio with those of other companies in the same industry, and examine trends in debt-to-equity ratios and free cash flow.
EBITDA
A popular valuation metric is Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA), with application for example to valuing unlisted companies and mergers and acquisitions.
For an attractive investment, for example a company competing in a high growth industry, an investor might expect a significant acquisition premium above book value or current market value, which values the company at several times the most recent EBITDA. A private equity fund for example may buy a target company for a multiple of its historical or forecasted EBITDA, perhaps as much as 6 or 8 times.
In certain cases, an EBITDA may be sacrificed by a company, in order for the pursuance of future growth; a strategy frequently used by corporate giants, such as, Amazon, Google and Microsoft, among others. This is a business decision that can impact negatively on buyout offers, founded on EBITDA and can be the cause of many negotiations, failing. It may be recognized as a valuation breach, with many investors maintaining that sellers are too demanding, while buyers are regarded as failing to realize the long-term potential of, expenditure or acquisitions.
Capital gains taxes
The amount to pay in taxes for long term investments, investments that span over a year long term, and short term investments such as those that are below a year are different. The long term investments range from Zero to twenty percent for capital gains and they are regulated by what tax bracket you are in for income taxes. For the zero to fifteen percent income tax bracket you could qualify for the zero percent long-term capital gains rate. The next bracket is the fifteen to twenty percent income tax bracket where you are set at fifteen percent capital gains tax for long term investments. The next bracket is between twenty and 39.6 percent and that leads to a twenty percent capital gains tax however with these numbers you should add 3.8 percent for the health care surtax. The short term capital gains tax is also related to your total taxable income and is taxed at the same rate as your income and ranges from ten to 39.6 percent.
Types of financial investment
Types of financial investments include:
• Alternative investments
• Traditional investments
An alternative investment is an investment in asset classes other than stocks, bonds, and cash. The term is a relatively loose one and includes tangible assets such as precious metals, art, wine, antiques, coins, or stamps and some financial assets such as real estate, commodities, private equity, distressed securities, hedge funds, carbon credits, venture capital, film production and financial derivatives. Investments in real estate and forestry are also often termed alternative despite the ancient use of such real assets to enhance and preserve wealth. Alternative investments are to be contrasted with traditional investments.
Research
There is a wide variety of literature on alternative investments; however, this term has been used broadly and can also refer to financial alternatives such as derivatives or other alternatives such as energy. It is difficult to find research on the investment characteristics of tangible alternatives such as art or wine due primarily to a lack of good quality data. The Goizueta Business School at Emory University has established the Emory Center for Alternative Investments to provide research and a forum for discussion regarding private equity, hedge fund, and venture capital investments.
As with any investment, it’s important to do your homework, but in the case of many alternative investments, some specialist knowledge on the specific asset is often needed. Therefore it’s important that would-be investors have a reputable broker or investment company on their side with demonstrable success in their asset class arena, which are happy to work with you to identify your ideal investment solutions.
How to access alternative investments
In recent years, the growth of alternative finance has opened up new avenues to investing in alternatives. These include the following:
Equity crowdfunding
Most people will recognise this form of alternative finance from the popular shows Dragons' Den (UK) and Shark Tank (US). Equity crowdfunding platforms allow 'the crowd' to review early-stage investment opportunities presented by entrepreneurs and take an equity stake in the business. Platforms differ greatly in the types of opportunities they will offer up to investors, how much due diligence is performed, degree of investor protections available, minimum investment size and so on. Equity crowdfunding platforms have seen a significant amount of success in the UK and, with the passing of JOBS Act Title III in early 2016, are now picking up steam in the US.
Investor-led crowd funding
The investor-led model was introduced by UK-based crowdfunding platform SyndicateRoom and makes it necessary for any startup seeking funding to first be vetted by an experienced investor that is also investing a significant amount (25% or more) of the target round. This approach has received largely positive feedback in the UK.
SEIS and EIS funds
Only available in the UK, SEIS funds and EIS funds present a tax-efficient way of investing in early-stage ventures. These work much like venture capital funds, with the added bonus of receiving government tax incentives for investing and loss relief protection should the companies invested in fail. Such funds help to diversify investor exposure by investing into multiple early ventures. Fees are normally charged by the management team for participating in the fund, and these can end up totalling anywhere between 15% and 40% of the fund value over the course of its life.
Private equity
Private equity consists of large-scale private investments into unlisted companies in return for equity. Private funds are typically formed by combining funds from institutional investors such as high-net-worth individuals, insurance companies, pension funds etc. Funds are used alongside borrowed money and the money of the private equity firm itself to invest in businesses they believe to have high growth potential. In Europe, venture capital, buy-ins and buy-outs are considered private equity.
Investors
The Merrill Lynch/Cap Gemini Ernst & Young World Wealth Report 2003, based on 2002 data, showed high-net-worth individuals, as defined in the report, to have 10% of their financial assets in alternative investments. For the purposes of the report, alternative investments included "structured products, luxury valuables and collectibles, hedge funds, managed futures, and precious metals". By 2007, this had reduced to 9%. No recommendations were made in either report about the amount of money investors should place in alternative investments.
Characteristics
Alternative investments are sometimes used as a way of reducing overall investment risk through diversification.
Some of the characteristics of alternative investments may include:
• Low correlation with traditional financial investments such as stocks and bonds
• It may be difficult to determine the current market value of the asset
• Alternative investments may be relatively illiquid (see "Liquid alts")
• Costs of purchase and sale may be relatively high
• There may be limited historical risk and return data
• A high degree of investment analysis may be required before buying
Liquid alts
Liquid alternatives ("alts") are alternative investments that provide daily liquidity. Liquid alternative investments should produce returns uncorrelated to GDP growth must have protection against systemic market risk and should be too small to create new systemic risks for the market. Hedge funds may be included in this category; however, traditional hedge funds may have liquidity limitations, and the term is usually used for registered mutual funds which use hedge fund strategies such as long-short equity equity investments.
United States
Liquid alternatives became popular in the late 2000s, growing from $124 billion in assets under management 2010 to $310 billion in 2014. However, in 2015 only $85 million was added, with 31 closed funds and a high-profile underperformance by the largest long-short equity fund at the time, Marketfield Fund. In 2014 there were an estimated 298 liquid alternative funds with strategies such as long-short equity funds; event driven, relative value, tactical trading (including managed futures), and multi-strategy. This number does not include option income funds, tactical shorting and leveraged indexed funds.
There has been expressed skepticism over the complexity of liquid alts and the lack of able portfolio managers.
In finance, the notion of traditional investments refers to putting money into well-known assets (such as bonds, cash, real estate, and equity shares) with the expectation of capital appreciation, dividends, and interest earnings. Traditional investments are to be contrasted with alternative investments.
Bonds
Here the investor purchases debt issued by companies or governments which promises to pay an annual return until the debt is repaid. The value of the investment changes as the level of general interest rates fluctuates, causing the bond to become more or less valuable.
Cash
In cash investing, money is typically invested in short-term, low-risk investment vehicles like certificates of deposit, money market funds, and high yield bank accounts.
Real estate
Real estate investing
In real estate, money is used to purchase property for the purpose of holding, reselling or leasing for income and there is an element of capital risk.
Residential real estate
Investment in residential real estate is the most common form of real estate investment measured by number of participants because it includes property purchased as a primary residence. In many cases the buyer does not have the full purchase price for a property and must borrow additional money from a bank, finance company or private lender.
Commercial real estate
Commercial real estate consists of apartments, office buildings, retail space, hotels, warehouses, and other commercial properties. Investors may purchase commercial property outright, with the help of a loan, or collectively through a real estate fund.
Real estate investment trusts
Investment in real estate investment trusts (REITs) is like investing in a pool of real estate that the company manages.
Stocks and shares
This involves purchasing a share in the equity of a company in the hope that the share price will increase. Purchasing a share in the company is the same as owning part of the company. Stock investing can come in the form of buying individual stocks, mutual funds, index funds and exchange traded funds (ETFs).
