Investors
Investors
INVESTMENT IN ECONOMICS LITERATURE
INVESTMENT IN FINANCE LITERATURE AND ORDINARY USE
The term investor is widely used not only by economics and finance academics and professionals, but also by ordinary people. An investor is an individual or an organization that makes an investment. The term investment itself is interpreted differently by the common public and finance professionals on the one hand, and by academic and professional economists on the other.
INVESTMENT IN ECONOMICS LITERATURE
In economics, investment refers to resources used to increase capital stock. The items included are expenditure on:
- Plants (machines) and equipments.
- Structures (factories, office building, etc.).
- Inventories (of finished and unfinished goods).
- New residential houses.
Moreover, the above items must be the result of current production. Suppose, for example, that General Motors (GM) spends $20 million in 2007 to build a new automotive factory to produce cars based on alternative fuel. GM will be considered by economists to have invested $20 million in 2007. This investment will add to the capital stock (the accumulated value of all capital: plants, equipment, buildings, factories, etc.) owned by GM at the end of 2006. However, if GM buys in 2007 a factory that Ford had utilized through 2006, economists will not consider the transfer of the automotive factory as investment from the nation’s point of view. This is because the factory Ford sold is not new—it is not the result of production in 2007. The purchase of the Ford factory by GM merely reflects a change in ownership of existing capital. Similarly, if you buy a five-year-old mansion for $7.5 million, it is not considered investment by economists, but buying a new mansion will be counted as investment.
Notice that even long-lasting new things that consumers buy are not counted in investment, except for new houses. Suppose you spend $150,000 to buy a new seaworthy boat, and $90,000 to buy a new condominium. The condominium will be counted as investment, but not the boat (which is actually more expensive). The boat is considered a consumption item, not an investment item. However, if a business had bought the same new boat to operate a sightseeing tour, it would be considered an investment item.
Economists also distinguish between net and gross investment. This distinction is necessitated by the fact that there is a wear and tear of capital stock as it is used in the production process—that is, the capital stock depreciates. Thus, investment that includes depreciation is called gross investment, and after the value of depreciation is subtracted from the gross investment, the resulting amount is the net investment. The nation’s capital stock during any year rises by the extent of net investment. The part of current income that consumers do not consume is called saving. It is this saving that largely finances investment by businesses, and leads to an increase in the capital stock of the nation. The widely used term capitalism is based on the notion of an economic system that is based on ownership of capital.
INVESTMENT IN FINANCE LITERATURE AND ORDINARY USE
The use of the term investment in finance and by ordinary people refers to buying an asset. The asset can be a financial instrument, commonly called a security (such as stocks, bonds, and a certificate of deposit or CD) or a real object (such as real estate, gold, and paintings).
To understand the notion of an investor, one should look at the various types of investments that he or she could invest in. The choice of the investment vehicle by an investor indicates how much risk the investor is willing to take. The following describes the major categories of investment or assets.
Equity or stocks represent ownership in a company or business. If you own 10 percent of GM stocks, you literally own 10 percent of GM. Equities constitute a major asset class. Stocks are considered risky in the sense that you can lose money if their value falls or if the company goes bankrupt. Stock investors of Enron, a U.S. public corporation that went bankrupt in 2001, were left with stocks that were worthless. Ownership of stocks can change frequently—they are traded on stock exchanges or computer-linked systems.
Bonds are the second most prominent asset class. A bond, also called a debt security, represents a loan made by an investor to a borrower. Normally, a bond has a maturity period of one to thirty years. The maturity period of a bond indicates in how many years the loan is due to be repaid. Thus, an investor holding a ten-year GM bond will receive periodic interest payments (usually twice a year) from GM and will receive the principal amount loaned at the end of the ten-year period. There is risk associated with bonds as well, because the borrower may be unable to pay interest and the principal on time or not at all. This is called default risk. If a company goes bankrupt, the bondholders as lenders have claims on the company’s assets. The company’s assets when sold may provide to the bond investors, say, fifty cents for every dollar lent. Stockholders, being owners, do not get anything at all in this case. Two major entities provide default-risk ratings in the United States: Moody’s and Standard & Poor’s. Bonds issued by the U.S. Treasury are considered default-risk free.
Money market instruments are the third important asset class. They are also debt instruments like bonds, except that the maturity period is one year or less. Because fewer things can go wrong in a year, a money market instrument is less risky than stocks or bonds. In fact, the money market is a way for an investor to hold cash (a liquid or cashlike asset). By investing in money market instruments, an investor has a relatively riskless asset, while still earning some interest income.
In addition to the preceding three widely utilized assets, there are other assets that an investor may choose to invest in. These include (among others): real estate (ownership of land or buildings); foreign exchange or currency (U.S. dollars, yen, euros, etc.); commodities (precious metals, crude oil, soybeans, etc.); derivatives (such as options and futures—these financial instruments are derived from or based on other financial securities); and works of art or other collectibles.
To distinguish between the notion of investment as used in finance and economics, investment in items such as plants and equipment is called simply investment, whereas investment in financial securities is called portfolio investment.
The choice of security indicates the extent of risk an investor is willing to take—the greater the risk, the greater the expected return on the investment. A risk-averse investor tries to diversify within an asset class or across asset classes.
RELATED TERMS IN USE
One will encounter a large number of terms in the context of discussing an investor or an investment. The following provides a nonexhaustive list of terms that have not been mentioned above: individual investors (including trusts on behalf of individuals, and umbrella companies formed to pool investment funds from two or more investors), angel investor (an affluent person who provides capital for a business start-up), amateur investor (often indicating an individual who invests blindly or is influenced by romantic notions rather than hard facts), venture capital funds (which provide start-up capital in lieu of a share of the business), financial intermediaries, banks, mutual funds, pension funds, hedge funds, insurance companies, investment banks, investment trusts (such as real-estate investment trusts), and regulatory institutions (such as the U.S. Securities and Exchange Commission or SEC).
SEE ALSO Equity Markets; Finance; Financial Markets; Investment; Investors, Institutional; Risk; Stock Exchanges
BIBLIOGRAPHY
Froyen, Richard T. 2005. Macroeconomics: Theories and Policies. 8th ed. Upper Saddle River, NJ: Pearson/Prentice Hall.
Mishkin, Frederic S. 2007. The Economics of Money, Banking, and Financial Markets. 8th ed. Boston: Pearson/Addison Wesley.
Mittra, Sid. 2005. Practicing Financial Planning for Professionals. 9th ed. Rochester, MI: RH Publishing.
Saunders, Anthony, and Marcia Millon Cornett. 2007. Financial Markets and Institutions: An Introduction to the Risk Management Approach. 3rd ed. Boston: McGraw-Hill/Irwin.
Anandi P. Sahu