What is an Investment?
A financial investment is any asset or instrument purchased with the intention of selling said asset for a price higher than the purchase price at some future point in time (capital gains), or with the hope that the asset will directly bring in income (such as rental income or dividends). This guide will review the three main investment methods (or asset classes).
The exact criteria for a transaction to be considered an investment, however, is not so concrete. From a broad perspective, there are many different categories of investments. Especially in terms of accounting, different transactions may be constituted as investments by different people. For example, a lease transaction may be seen as an investment by some but not by others.
In a very broad definition, an investment can encapsulate any action or operation undertaken with the intention of generating some form of future income. As such, even the act of producing goods with the intention of reselling them in the future can be seen as an investment.
There are certain types of transactions that are easily seen as financial investments. These are the focus of this article and are described below.
What are the Different Investment Methods?
A simple way of classifying investments is to divide them into three categories or “investment methods” which include:
- Debt investments (loans)
- Equity investments (company ownership)
- Hybrid investments (convertible securities, mezzanine capital, preferred shares)
Debt-based investments can be further broken down into two sub-categories – public and non-public (private) investments.
Public debt investments are any investments that can be purchased or traded in open debt markets. These are such things as bonds, debentures, and credit swaps, among others. A company will often classify public securities as held-to-maturity, available-for-sale, or held-for-trading. Each of these classifications has certain criteria and specific treatments under accounting standards.
Private debt investments are any transactions that generate an asset on the balance sheet and are not openly or easily traded in markets. An example is the purchasing of another entity’s accounts receivables or loan receivables, which are expected to generate some form of future income.
Equity investments can also be categorized as public and non-public investments. The latter is commonly known as Private Equity, which is considered a high risk, high reward investment. In fact, equity investments are generally seen as riskier than debt investments, with the advantage of potentially generating higher returns.
Public equity investments are any equity-based investments that can be purchased or traded in markets. These are often the type of investments that someone has in mind when discussing investments. This covers such instruments as common stock, preferred stock, stock options, and stock warrants.
Private equity investments are often larger-scale investments that are not within the scope of a small investor. Leveraged buyouts, mergers and acquisitions, and venture capital investments are just some of the more commonly undertaken types of private equity transactions.
Hybrid Investment Methods
Let’s look at some additional investment methods. There are investment types that mix elements of both debt and equity. An example of this is mezzanine debt, in which an investor provides a loan to a second party in exchange for equity. Another example is a convertible bond, in which an investor has purchased a bond that has a feature whereby it is exchangeable for a certain number of stock shares of the issuing company.
There are also investment types that possess neither debt nor equity components. An example of this type is any investment into the asset side of the balance sheet, such as the purchase of equipment or property under PP&E. Alternatively, purchasing intangible assets such as a brand or patent can also be classified as an investment, depending on the strategy.
Finally, there is a large class of investments called derivatives, which – as the name implies – are derived from other securities. There are many kinds of derivatives, all of which merit an article of their own. However, examples of commonly known derivatives are futures and options, which are investment instruments that base their value off an underlying stock or commodity.
Read more about Investing!
CFI offers a number of informative resources on investing, including the articles listed below.