Investment is the action of purchasing something today, called an asset, with the goal of having it increase in value over time such that it is worth more in the future than it is today. The amount that the asset appreciates is called the investment return. For example, an asset that doubles in value appreciates 100%. The return is normally annualized for easy comparison so that we know what the annual return or annual growth rate is.
Compounding occurs when an asset creates a return which is reinvested in order to generate its own return. With compounding, the value of the investment increases exponentially. In fact, given enough time, the return generated on the reinvested money will surpass the return on the initial investment. This is why it is so desirable to invest early for retirement. For example, an asset returning 5% for 20 years returns 100% of the original investment without compounding. An asset compounding at 5% for 20 years will return 165%.
Investable assets, or asset classes, consist of stocks, bonds, cash equivalents and alternative assets.
Stocks are shares in ownership of a business. Some businesses pay money back to shareholders in the form of dividends. The return of a stock is the sum of the dividends paid plus the current value of the stock divided by the initial value of the stock. Certain indexes, such as the S&P 500, track a large percentage of the market of U.S. stocks. There are numerous other indexes that track other markets or pieces of markets. For example, the MSCI EAFE index tracks international markets, while the MSCI Healthcare index tracks healthcare. Index Funds are designed to track certain chosen indexes with low expense.
Bonds are debt instruments and are basically loans. The issuer of the bond pays the purchaser a specified interest rate over the life of the bond plus the original value of the bond. Bonds can be issued by the government, municipalities, corporations or certain federal agencies. Treasury bonds issued by the government and backed by the full faith and credit of the US government have lower default risk and therefore lower interest rates than other bonds of equivalent length. Bonds' interest rate normally increases with bond length due to an increase in perceived risks such as default or inflation.
Cash Equivalents such as money market or treasury bills are characterized by high liquidity and less than three month maturity. These are considered to be the equivalent of cash.
Alternative Assets are assets other than stocks, bonds or cash and cash equivalents. These assets include real estate, commodities and precious metals.
The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.
The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.
Performance data showing past performance results is no guarantee of future returns.