An investment basically involves the purchase of an asset which is expected to yield income or profit in the future. Since there are different investment options out there, you need to weigh all your options carefully before laying down a kobo of your hard earned money. You may also borrow to make an investment, in which case you have to be extra careful, since you are not the only one involved.
It’s quite easy to spend on things that initially seem like sound investments, only to turn out to be liabilities. So, in this article, we will look at the 3 basic types of investments and you should consider them.
By the time we are through with this, you will be able to decide the options that are right for you.
Types of investment: We will group investments into lending investments, ownership investments, and cash equivalents. Let’s take them one at a time.
Lending investments: Lending investments are low-risk in nature. As a result, they also have low returns. It involves you lending your money to institutions or the Government and getting interest after a given period of time. Examples of such investments include bonds and your savings account.
1. Bonds: When you buy a bond, you get interest payments after a set period of time. The payment will depend on the interest rate agreed upon by the issuer of the bond. At the end of the duration, the bond issuer repays the face value of the bond.
Bonds are considered more stable investments than stocks. They provide a steady flow of income, but the long-term return will be less when compared to stocks. However, it’s possible that sometimes bonds can outperform the rate of return of a particular stock.
Common risks for bond investors are:
- Inflation risk: The return you earn on your investment might not consider inflation. For instance, if you hold a bond that’s paying an interest rate of 3%, and inflation reaches 4%, your return will be negative (-1) when adjusted for inflation. Although you will get your principal back, it will be worth less than it does today.The longer you hold a bond, the higher the inflation risk.
- Credit risk: You stand the chance of losing your money if you purchase bonds from a company or Government that is financially unstable. This is known as credit risk or default risk. It’s possible that the issuer won’t pay back the face value of the bond when it matures or simply can’t make the interest payments.
- Interest rate risk: When interest rates fall, bond prices rise, and vice versa. This poses a risk if you need to sell a bond before its maturity date and the rates are up. You may end up selling for less than the amount you paid for the bond.
- Market risk: The entire bond market may decline. If that happens, the price of your investment will fall regardless of the quality of bonds you hold. If you decide to sell, you’ll earn less than the cost of purchase.
2. You savings account: You can deem yourself an investor even if you have just a savings account, but no other investment. This is because with your savings account, you are basically lending your money to the bank, which the latter gives out as loans.
Although the returns are extremely low, risks almost do not exist as long as your money is in a trusted bank.
Ownership investments: After lending investments come ownership investments. They are basically what come to mind for most people when they think of the word “investment”. They are the most profitable and volatile investment class. They include stocks, real estate, businesses, collectibles and precious objects.
1. Business: You make an investment when you put money into starting a business or running an existing one. Being an entrepreneur is one of the hardest types of investment as it requires more than just money. It can yield extremely large returns, as you could make a fortune by creating a product or service that is in high demand.
However, there are common risks for business investors as you can see below-
- Company risk: This type of risk occurs when you make bad business decisions, produce goods or services that do not meet consumer demand, or struggle to maintain positive cash flows.
- Credit risk: Credit risk is when you are unable to pay back investors or pay out investment contracts.
- Political risk: This type of risk occurs when international or domestic regions make changes to the business environment. Common political risks include high taxation rates, increased government regulation, war, terrorist attacks, or military coups. These create significant disruptions in the market.
2. Stocks: A stock is a certificate that says you own a portion of a company. When you purchase one, you are basically buying a piece of the company’s assets and earnings, as well as the right to perform certain action (as in a futures contract). Companies sell shares of stock to the public with the purpose of raising cash. Investors can then buy and sell the shares amongst themselves.
Your profit depends on how the market values the assets you own the rights to. If the company is doing well, other investors are going to want shares. The increased demand drives up the price. If you sell at such a time, you can earn great returns – this is known as appreciation or capital gain. Some stocks also pay dividends. These are regular distributions of a company’s earnings to its investors.
Shares offer some degree of protection against inflation, unlike bonds.
Stocks earn high returns but are often riskier than other types of investments. You can lose your money if the company loses value or goes out of business.
Some of the major types of risk for stocks investors include market value risks, economic risks, and inflation risks.
3. Real estate: These include land, houses, and other structures that you buy to rent out or renovate and resell for profit. It has a high profit potential and can provide steady cash flow in perpetuity.
Building a private residence cannot necessarily be considered as an investment because although it may appreciate over time, it is not acquired with the expectation of making profit.
Common risks in real estate investment are-
- Depreciation risks: Real estate properties are expected to increase in value over time. However, it’s also possible that a property can drop in value in the future and you’ll end up losing money.
- Location risks: Location is everything in real estate. If the area faces trouble in the future – perhaps it doesn’t develop as fast as you expect, or there’s a crises, and so on – you may end up losing money.
- Liquidity risks: Liquidity is the ability to access the money you put into an investment. Real estate properties may not be easily converted to cash. Selling is neither a quick nor easy process. And you may lose money if you sell under pressure.
Other risks include foreclosure, negative cash flow, structural issues, vacancy issues, and bad tenants.
4. Collectibles and precious items:
Gold, jewelry, art works and artifacts, and so on are some examples of ownership investments. These items hedge against inflation and are highly liquid.
However, there may be risks of physical depreciation or damage.
Cash equivalents: These investments protect your capital and allow you access to your money. They also deliver a more stable rate of return. They are, however, not designed for long term investment goals such as retirement. They include certificates of deposit (CDs) and money market accounts.
1. Money market account: These are savings accounts that may come with a higher interest rate than basic savings accounts. They however require higher minimum deposits and balances.
2. Certificate of deposit: A CD is a savings certificate with a fixed maturity date and interest rate. It is a promissory note issued by a bank (commercial banks). It restricts access to funds until the maturity. You may pay a fee if you withdraw before the agreed time.
Non-investments: Now that we have seen some of the ways you can invest your money, it is necessary that we also learn what does not count as an investment.
Consumer purchases are not investments. These include cars, mobile phones, beds, TVs, and so on. Anything that depreciates over time with use and time is not an investment – although they add to your net worth. You won’t expect anyone to pay more than the initial purchase cost, unless maybe you are a celebrity.
As a final note, it’s important to remember that spending on personal development is a highly valid investment. Improving your skills increases your potential for higher earnings.