Page 69 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Personal Financial Planning

Notes 4.2 Types of Investment

The term “investment” is used differently in economics and in finance. Economists refer to a real
investment (such as a machine or a house), while financial economists refer to a financial asset,
such as money that is put into a bank or the market, which may then be used to buy a real asset.
In business management the investment decision (also known as capital budgeting) is one of the
fundamental decisions of business management: managers determine the assets that the business
enterprise obtains. These assets may be physical (such as buildings or machinery), intangible
(such as patents, software, goodwill), or financial. The manager must assess whether the net
present value of the investment to the enterprise is positive; the net present value is calculated
using the enterprise’s marginal cost of capital.
A business might invest with the goal of making profit. These are marketable securities or
passive investment. It might also invest with the goal of controlling or influencing the operation
of the second company, the investee. These are called intercorporate, long-term and strategic
investments. Hence, a company can have none, some or total control over the investee’s strategic,
operating, investing and financing decisions. One can control a company by owning over 50%
ownership, or have the ability to elect a majority of the Board of Directors.
In economics, investment is the production per unit time of goods which are not consumed but are
to be used for future production. Examples include tangibles (such as building a railroad or
factory) and intangibles (such as a year of schooling or on-the-job training). In measures of national
income and output, gross investment I is also a component of Gross Domestic Product (GDP),
given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending,
and NX is net exports. Thus investment is everything that remains of production after consumption,
government spending, and exports are subtracted I is divided into non-residential investment
(such as factories) and residential investment (new houses). Net investment deducts depreciation
from gross investment. It is the value of the net increase in the capital stock per year.
In finance, investment = cost of capital, like buying securities or other monetary or paper
(financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as
gold, real estate, or collectibles. Valuation is the method for assessing whether a potential
investment is worth its price. Returns on investments will follow the risk-return spectrum.

The important options available for investment are as follows:
Cash investments: These include savings bank accounts, certificates of deposit (CDs) and treasury
bills. These investments pay a low rate of interest and are risky options in periods of inflation.

Debt securities: This form of investment provides returns in the form of fixed periodic payments
and possible capital appreciation at maturity. It is a safer and more ‘risk-free’ investment tool
than equities. However, the returns are also generally lower than other securities.
Stocks: Buying stocks (also called equities) makes you a part-owner of the business and entitles
you to a share of the profits generated by the company. Stocks are more volatile and riskier than
bonds.
Mutual funds: This is a collection of stocks and bonds and involves paying a professional
manager to select specific securities for you. The prime advantage of this investment is that you
do not have to bother with tracking the investment. There may be bond, stock- or index-based
mutual funds.
Derivatives: These are financial contracts the values of which are derived from the value of the
underlying assets, such as equities, commodities and bonds, on which they are based. Derivatives
can be in the form of futures, options and swaps. Derivatives are used to minimize the risk of
loss resulting from fluctuations in the value of the underlying assets (hedging).

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