Investing Part 1: What is an Investment?
As we’ve previously discussed, the easiest, most reliable way to grow your wealth is to spend less than you make and invest the difference. Spending less is pretty straightforward; investing, on the other hand, is a broad term that has a long-standing reputation of being confusing, time-consuming, and risky. But this doesn’t have to be the case. Fortunately, we’ll clear things up and debunk these myths to prove just how easily anybody can jump right in. Let’s start off with discussing what exactly defines an investment.
What is an Investment?#
Two of the most common types of investments include stocks and real estate. But what specifically qualifies them as investments? And how do you differentiate an investment from any other purchase?
Let’s take a look at Investopedia’s1 definition of investment:
An investment is an asset or item acquired with the goal of generating income or appreciation. …An investment always concerns the outlay of some asset today—time, money, or effort—in hopes of a greater payoff in the future than what was originally put in.
Simply put, an investment is just trading time, money, or effort today for the potential for more money later.
How Do Investments Make Money?#
There are two methods by which investments provide value to their investors: cash flow, which allows the investor to periodically collect income generated by the asset, and appreciation, which is when an item increases in value over time.
There are plenty of examples of each, and some investments even fit into both categories. Common cash flowing investments include purchasing rental properties, starting a business, buying dividend stocks (shares of a company or fund that periodically pays you part of their earnings for owning those shares), and buying bonds (loans to a company or government that collect interest over time… more on this in another post). These examples all ideally provide income, though the effort and time required to obtain that income varies between them.
As for investments that take advantage of appreciation, some examples include real estate and growth stocks (shares of a company or fund that does not pay you for owning the shares but tends to grow in value more quickly). Investors buy these assets at some price today in hopes that they can sell them at a higher price in the future. Real estate and stocks are two examples of investments that can provide both cash flow and appreciation over time.
Investments vs Everything Else#
Armed with this information, you can quickly determine whether or not an asset qualifies as an investment. Let’s use a new TV as an example. Does the TV provide cash flow? In other words, when you buy a new TV, do you then get paid to own it? Probably not. Does that TV appreciate in value? Again, this is unlikely. Since the TV doesn’t fit into either category, we can safely say it’s not an investment.
Using this simple thought process makes it easier to redirect your spending away from the “everything else” and into investments. The more money that you invest, the more money your investments will provide you. And eventually they’ll fund everything else, forever.
Conclusion#
Now that we’ve addressed the confusion regarding what is and isn’t an investment, hopefully the fog along the path to financial independence is lifting. In the next post, we’ll discuss how you can invest in a way that requires practically no time or effort on your part, as well as strategies to mitigating risks.