There are just three ways that an investment can make money. One, by lending money to someone who pays interest on it, be it a business or a government. Two, by becoming a part owner of a business, as in having a share in it. And three, by buying something that becomes more valuable, like gold or real estate.
The universe of investment options boils down to just these three components. This simplifies the task of understanding investments. Step one of understanding each investment would be to think along these terms.
When you own shares (or equity, as it is often called) in a business, you could make big profits if the business does well, or make losses if it does badly. The risks are high, and the potential of reward is also high.
When you lend to a business (by making a bank deposit, for example), your gains are limited to the interest rate that the business has agreed to pay you. No matter how successful that business may become, you are not going to get more than that.
In the third kind of investment, you buy something, if the price goes up that’s great and if it goes down then you lose money.
In investing jargon, the first type (lending) is called debt, or fixed income investing. The second type (owning) is called equity investing, with stock or shares being synonyms for equity. These terms are called ‘asset types’. Almost everything that you invest in can be classified as one of these asset types. For example, bank deposits or company deposits are debt while buying shares or investing in equity mutual funds is equity.
While there are a lot of ways in which investments differ from each other, there are three basic characteristics that define any investment:
Risk: The likelihood of an investment not fetching the return you expect from it
Returns: How much returns does the investment fetch
Liquidity: Whether you can withdraw your money at any time
Each of these three factors have some nuances to them. Risk can be defined as the likelihood of loss, or the likelihood of not getting the expected return. Generally, debt has the lowest risk and equity the highest. However, there are many variations to this idea. For example, debt investments in failing businesses can be very risky and there are many ways of managing risk levels in equity.
Returns are the main goal of any investment and they are the flip side of risk. Normally, higher returns come with higher risk. Again, the defining example of this is the debt to equity comparison. Debt investments have less risk and low returns but equity can have higher returns with higher risk. There are huge variations within equity and it’s perfectly possible to have higher risk as well as poor returns. In fact, that’s what most careless or overconfident equity investors actually get.
Liquidity is about getting your money back on demand. For example, if you keep your money in a savings bank account, you can walk into any ATM anywhere in the world and immediately withdraw it, subject to some limits. If you go into a bank, you can withdraw all of it. In some investments, there could be a penalty for liquidity. In a fixed deposit, you either wait for the whole term, or you settle for less returns. In equity, liquidity varies from stock to stock.