Understanding Investing

Definition of Investing

Investing is the act of committing resources towards an endeavour or entity which, upon thorough analysis, promises satisfactory return and safety of principal.

There are four key components in this definition:.

1. In economics, a resource is a service or asset that can be used to produce goods and services that meet human demands. Examples include: money, time (i.e. labour), land, raw materials, infrastructure, machinery, computation power et cetera.
2. Thorough analysis involves establishing, with the highest possible degree of certainty, the expected return and the risk of permanent loss of resources committed towards an endeavour or entity.
3. A return is the difference between the value of input(s) and the value of output(s). If the output value exceeds that of the input, then the return is considered positive. Conversely, if the input value exceeds that of the output, then the return is considered negative. If the overall output and input are equal in value, then the return is considered flat and the investment can referred to as break-even. A satisfactory return is one that meets the desired risk-return profile of the individual. For example, a individual seeking higher returns will often have to take on a higher level of associated risk. The opposite also holds true.
4. Principal is the original sum of resources committed to an investment. Principal is considered safe if there is a very low risk of permanent loss (i.e. the value of the resources are preserved or recoverable).

As a side note, when most people refer to investing they are usually referring to financial investing. The same definition applies, but the resource committed to the endeavour, or entity, is money.

With this working definition of investing, two examples will be explored.

Example 1: General Investing

After thorough analysis of job prospects in a certain field, a student commits their time and money towards studying a relevant qualification with the expectation that the knowledge gained leads to a secure and well-paying job. In this example, the resources committed are time and money, the endeavour is acquiring knowledge, and the return is employment. It is important to note that the return would only be considered satisfactory if the employment was both secure and well-paying. If, for example, the potential gain (i.e. regular income) did not exceed the costs (i.e. time/money expended to study) then the return would be considered unsatisfactory.

Example 2: Financial Investing

After thorough analysis of a business' financial statements, competitive advantages, long-term prospects and the quality of management, $25,000 was committed to the business in exchange for equity. Based on the analysis, it was determined that there was a very low probability of permanent loss of principal, and that the business was expected to generate an annualised return of 10% over five (5) years which exceeds the hurdle rate of 8%. As the operation meets both the criteria of a satisfactory return and safety of principal, and the resource committed is money, the operation can be classified as financial investing.

Summary

To summarise, investing is the act of committing resources towards an endeavour or entity which, upon thorough analysis, promises satisfactory return and safety of principal. Any operations that do not meet this definition are speculative and should not be referred to as investing. Speculation will be covered in a subsequent lesson, however, if at any stage an individual discovers that they are not performing a thorough analysis or there is a high risk of loss of principal, then the operation is likely to be speculative.