Because I spent four years in college studying personal finance, most of the basic questions don’t occur to me any more. It’s called familiarity blindness. I’m just so used to this stuff that I no longer realize what other people might not know. That’s not to say they’re stupid. They just haven’t spent as much time studying these things.
Part of my purpose for writing on Provident Planning is to educate people. I want to teach people enough to make good financial decisions on their own. So it’s with that mindset that I’m approaching several topics from here on out by focusing on the basics. I’m planning on looking at the basics of investing, insurance, taxes, retirement planning, and estate planning. These will start off very basic (like today’s post), and I’ll look at more complex issues as time goes on. So let’s get on to today’s post.
What Is an Investment?
If you’re new to the idea of investing, a great place to start is to define what an investment is. An investment is simply anything you put money in with the expectation (or hope) that it will generate income and/or increase in value. An investment return is the reward you get from investing – basically current income or increased value.
For example, money in a savings account provides income in the form of interest payments. A share of stock is expected to increase in value over time while possibly providing income in the form of dividends. A rental home could be considered an investment because you expect to generate rental income while the property value increases over time. You can even consider education to be an investment because you expect it will help you earn more income or increase your value to employers. While that’s true, this series is going to look more at things like stocks, bonds, options, mutual funds, real estate, and other such traditional investments.
So that’s a basic definition of an investment – something that is purchased with the hope that it will provide income or go up in value. But be sure you don’t get “investing” and “speculating” confused. Investing involves the creation of wealth through legitimate means. Speculating is often a zero-sum game, where someone else has to lose so you can win. No wealth is created in speculating – it simply changes hands.
I had a professor in college (for an investment course) who I didn’t particularly like, but one thing he taught that never left me is the necessity of differentiating between investing and speculating.
He said you’re investing when you’re buying into a revenue stream; when you’re buying a security or tangible asset in the hopes that it will be worth more in the future, you’re speculating.
I think that’s a useful distinction, and probably points toward the need for serious investors to put the bulk of their money into income generating assets like dividend paying stocks, bonds and CDs, and putting only a small amount into chasing what we like to call “growth assets”, but are more likely blatant speculations.
After the stock market booms of the 80s and 90s it seems a lot of good people are having trouble identifying the difference, and maybe that’s why so many got hit so hard when the markets crashed twice since 2000.
.-= Kevin@OutOfYourRut´s last blog ..Blue Collar Jobs Can’t be Moved Offshore =-.
That’s a good distinction, Kevin. But I also think that the expectation of growth from stocks is not unreasonable (i.e., speculating). Prices for stocks are based in part on the future revenue streams we expect from them (dividends). But we can reasonably expect many stocks/companies to increase in value as well. That’s why stocks aren’t priced solely based on their current or future dividends.
With that said, many investors do overestimate their ability to pick stocks (or other assets) that will increase in value, which is just speculation.
There’s merit in what you’re saying of course, but at the same time, it’s probably best that the average person doesn’t commit too much of his or her funds to that expectation, as if it’s success is a given.
A lot of people go into the stock market without being fully aware of the risks they’re taking on. When the market’s rising everyone’s convinced it’s working as it should, but it’s often only when it slides in a major way that we begin to ask “what was I thinking?”
The first rule of investing is not to lose money!
.-= Kevin@OutOfYourRut´s last blog ..Blue Collar Jobs Can’t be Moved Offshore =-.