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Investing, From First Principles

Investment, stated simply, is the action of taking money that is already safe in your pocket and putting it to work in order to earn a return in the future. Most people invest money to grow it over time in order to stay ahead of inflation, and/or meet future financial goals.

Money can be invested in one of two ways: either through ownership of an asset (e.g. buying a plot of land, rental units, a small business, a share of listed company, a unit or share of an investment fund), or through lending (e.g. lending to a bank through a fixed deposit, to government through a Treasury bill or bond, to large companies through a corporate bond, to small businesses or even friends through a promissory note).

Benefits ownership

Whenever you own an asset for the purpose of investment, you hope for one of two things to happen. Either you want the value of the asset to increase during the time of your ownership, and/or you want that asset to generate cash flows for the period of ownership. There is no limit to the potential earning from ownership since the asset could in theory increase in value up to infinity.

Notice that ownership gives the owners (sometimes known as shareholders) rights to benefit from appreciation in value of the asset they own, and/or the right to income generated by the asset. Ownership benefits accrue to the shareholders without regard to the actual nature of the asset. The investment asset can be in form of land, rentals, small business, and fractional ownership of a large business (e.g. a listed company or unit trust fund).

Benefits lending

Whenever you lend money to someone or to an entity for the purpose of investment, you want one of two things to happen. First, you expect to be paid back the principal amount lent after expiry of a stipulated time. Second, you expect to earn interest to compensate you for foregoing current consumption and for taking the default risk. The potential earnings from lending is limited to the interest rate agreed.

Risks of ownership

The general risk in owning an investment asset that confers shareholding rights arises when either the hoped-for increase in the value of the asset does not materialize or when the asset does not generate the anticipated cash flows, among other things. Therefore, your ability to accurately evaluate the future cash flows of the asset is a key determinant of your success as an investor.

Risks of lending

Whenever you lend someone or an entity money, you are always worried about their ability to pay you back the principal at the end of the contracted period and interest accrued. So your ability to accurately evaluate the credit risk of the borrower is key determinant of your success as an investor.

How much ownership and lending should you do

Depending on your goals, investment period, liquidity requirements, investment knowledge, and attitudes towards risk, the amount of investing you engage in through ownership and lending will vary. The investment advisor’s job is to evaluate your circumstances, and then recommend a combination that is optimal for achieving your financial goal.

I recommend a goal-based approach to investment where every investment asset/strategy is evaluated based on its ability to help you achieve your financial goal. Start with a well-articulated goal in mind (see examples here), evaluate your circumstances, getting a recommended optimal portfolio that can be executed using both ownership and lending to help you achieve your goals.

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