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Investing Basics

February 4th, 2010 Leave a comment Go to comments

What exactly is an investment? There is the dictionary definition. Investments can be many things, not limited by those of a financial nature. In the realm of finance, there are all sorts of things that can be investments. The easy part is defining what an investment is or is not, the hard part can be finding the ones that payoff, or in finding investments in places where it is not necessary obvious.

First, what an investment isn’t. To use an analogy, don’t confuse the basket with the fruit. The typical idea that is often written about in media, is that an investment is synonymous with an account (the basket). Accounts such as IRAs, 403Bs or 401Ks are often referred to as investments. These accounts are usually managed by third parties who largely determine or influence the individual components that they are made up. There are literally thousands of components that can be added to these accounts.

In order to understand the “fruit” in the basket, you would need to learn about the individual choices that can be made. Some of the choices include stocks, bonds, mutual funds, real estate investment trusts, master limited partnerships, etc.

Investments are not limited to those things that are publically traded entities, such as stocks and bonds. They can be all sorts of other things.¬†However, there are a few key traits of all of them have regardless of what it is or its how it’s structured or sold. They are:

  1. An investment is an asset with a price (value).
  2. Investments can change in value in the future (capital gain/capital loss).
  3. Investments generate earnings (profit), now or in the future.

The third point is the most important one. For our purposes, over the long term all investments should be evaluated based upon earnings even if the earnings do not exist or even if they never appear. An asset will change in value as time goes on as its potential or known ability to generate earnings becomes more known or changes.

Example 1 – New Jersey Land

Let’s start with a real life example, of a patch of land in New Jersey. A high school friend of my brother bought a patch of land on the perimeter of the Pine Barrens over 30 years ago. A former governor Brendan Byrne signed legislation that forever made the PB unavailable for commercial use. At the time he bought the property, land in that area was worth about $50/acre (there were no roads near it and overall there was little demand for this land due to its remoteness).

Fast forward 30 years later, NJ is experiencing a shortage of land for development. The land around the PB has been developed with roads and infrastructure such that his patch of land has increased in value. Even though the land has never earned any money, its potential earnings has increased due to demand and infrastructure upgrades that enable the land to be developed.

Example 2 – Coca-Cola Company (KO)

Coca-Cola is an investment that has been around for many decades. Every year it earns money. There are many Wall Street analysts who cover the company. It’s a very mature investment because its price is well known and is transparent because it is a publicly traded investment.

Compared to an patch of land that is undeveloped, KO is a less risky investment because a lot if known about their earnings.

Example 3 – A Social Media Company

A private company called SuperSocialSite (I made this up) has some great new social networking software for consumers. But as a company, it has little revenue much less profits. The company is growing like gangbusters and as time goes on, it continues to raise venture capital from investments so it can keep the lights on. It may not even be entirely clear how they could make money at all in the future.

Is this an investment?

Why, yes it is. The endgame here might be that their product will be sold to some other company (call them BigSocialSite) who does have products that earn money. So, the interests of the buying company is to perhaps protect and enhance their own earnings. So even though SuperSocialSite could perhaps never earn money, it can be valued as an investment by evaluating the impact it would have on the BigSocialSite’s earnings over the longer term.

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