What is an Investment?
A financial or economic investment is any asset or instrument purchased with the intention of selling said asset for a higher price at a future point in time (capital gains), or with the hope that the asset will directly bring in income. 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 its 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, however, 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 (convertible securities, mezzanine capital, preferred shares)
Debt-based investments can be further broken down into two sub-categories: the public and the 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 criterion and treatment under accounting standards.
Private debt investments are any transactions that generated an asset on the balance, and are not openly or easily traded in markets. Examples of these are 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 are considered high risk, high reward investments. In fact, equity investments are generally seen as riskier than debt investments, with the advantage of possibly generating more 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 may have in mind when discussing investments, and cover 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 low-capital investor. Leveraged buyouts, mergers and acquisitions, and venture capitalism 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 both elements of 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 where it is exchangeable for a certain number of shares of the issuing company.
There are also investment types that possess neither debt nor equity components. An example of this type of investment are any investments into the asset side of the balance sheet, such as purchase of equipment or property under PP&E. Alternatively, purchasing intangible assets like a brand or patent can also classify 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, an example of commonly known derivatives are futures and options, which are investment instruments that base their value off an underlying stock or commodity.
CFI offers a number of informative resources on investing, including the articles listed below.