Investment Explained: A Comprehensive Guide to Growing Your Wealth

Investment is the process of allocating capital to a financial instrument (e.g., stocksStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably., bonds) backed by an expectation to receive certain benefits in the future. In the financial world, the benefit of investment is referred to as a return.

The return can be either positive (gain) or negative (loss). Returns can be in the form of proceeds from the sale of an investment, an investment income, such as rental income, dividendsDividendA dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend., interest income, or unrealized capital appreciation (or depreciation), etc.

The return may also involve currency gains or losses as a result of the foreign currency exchange rate fluctuations. So, when a company exchanges the proceeds from one of its foreign subsidiaries into the home currency for financial statements consolidation, it may record currency translation gains or losses based on the currency exchange rate at the time of the transaction.

Summary

• Investment is an activity of capital allocation so it can produce a return in the future.
• The higher the risk, the higher the return investors will require as compensation.
• There are two strategies of investing: value investing and growth investing.

The Golden Rule

The golden rule of investing is as follows:

“The higher the risk, the higher the return.”

In other words, the higher the risk, the higher the return an investor would claim as compensation for taking the risk. So, when a low-risk investment is made, the return is going to be low as well and vice versa.

Investment Strategies

The two main investing strategies are as follows:

1. Value investing

Value investing represents an investment into an asset (e.g., security) that is estimated to be currently undervalued. To conclude whether a security is undervalued or overvalued, an investor performs a comprehensive financial analysis by calculating all the essential metrics and accounting ratios, such as earnings per share (EPS)Earnings Per Share (EPS)Earnings per share (EPS) is a key metric used to determine the common shareholder's portion of the company’s profit. EPS measures each common share's profit, sales growth, P/E ratioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio is the relationship between a company’s stock price and earnings per share. It provides a better sense of the value of a company., P/B ratio, etc.

In other words, value investors are focused on the current value of security without taking into account the potential future value growth of the security.

2. Growth investing

Growth investing is an investment aimed at increasing an investor’s capital in the future. Growth investors contribute capital to securities, such as stocks, that are expected to appreciate over the long term.

So, growth equity investors typically invest in young companies with high potential and whose earnings are expected to increase at an above-average rate compared to the overall industry.

Growth investing is enticing because, after investing in emerging companies for the long term, investors can receive substantial returns provided the company succeeds, and the value of the stocks increases significantly.

On the other hand, since emerging companies are new and untested, growth investing imposes a relatively high level of financial risk onto investors.

The five main factors a growth investor takes into account when evaluating stocks include:

1. Historical growth of earnings per share (EPS)
2. Future growth of the EPS
3. Profit margins (Gross profit margin, net profit margin)
4. Return on equity (ROE)Return on Equity (ROE)Return on Equity (ROE) is a measure of a company’s profitability that takes a company’s annual return (net income) divided by the value of its total shareholders' equity (i.e. 12%). ROE combines the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity.
5. Share price performance

Investment vs. Saving

Investing in a company with an unstable financial situation due to an economic crisis, for example, implies bearing the risk of a potential default of the company. Since the company is in financial distress, an investor would claim a higher interest rate to compensate for the level of risk.

If the company goes bankrupt, the investor will lose its invested capital, provided there is no option to claim it back from the company.

On the contrary, saving is simply an accumulation of money for future utilization. It is completely risk-free because capital is not employed, meaning it is just lying on a bank account.

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Investing: A Beginner’s GuideInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading
• Price to Sales RatioPrice to Sales RatioThe Price to Sales ratio, also known as the P/S ratio, is a formula used to measure the total value that investors place on the company in comparison to the
• Rate of ReturnRate of ReturnThe Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. This guide teaches the most common formulas
• Systematic RiskSystematic RiskSystematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or individual. Systematic risk is caused by factors that are external to the organization. All investments or securities are subject to systematic risk and therefore, it is a non-diversifiable risk.