In our day-to-day lives, we come across many people around us talking about investments. For example, I have invested “x” amount of money in real estate, stocks, bonds, business, etc. Now the question arises what an investment is?
Have you ever thought about what an investment is? What is the definition of investment and how can we say whether this is an investment or not? A lot of people have the same questions revolving in their minds. So, in this blog, we are going to learn about it.
Let’s take an example, during most of the part of our lives hardly over income will be exactly equal to our consumption. Sometimes, it will be more than our consumption and sometimes it will be less than our consumption. Now, when it is more than our consumption, we will usually save the excess and will borrow in case of less than our consumption. Now the next question is what we will do with our savings? Either we can put it in a safe locker for the future when our consumption exceeds our income or give up the savings immediately to get in the future a larger amount of money. In the first case, when we open the locker after years, we will get the same amount that we put into it but in the second case, we will get a larger amount than we gave up. So, this trade-off of the present consumption with the high level of future consumption (deferred consumption) is known as investment.
Coming towards the formal definition of investment, it is the current commitment of funds for a time period to get payments in the future that will accommodate for
- The time the funds are committed.
- The expected rate of inflation
- The uncertainty of future payments.
In all cases discussed above, the investor is giving up a known amount of funds (dollars) for payments that he/she will get in the future, that will be greater than the amount of funds he/she gave up today. So, in short, people invest to get a return from their excess amount i.e., savings due to their future/deferred consumption. And the return they want compensation for the time period of the investment, the expected rate of inflation in the investment period, and the uncertainty of the cash flows that are going to come in the investment period or at the end of it. This return that they want is known as a required rate of return.