Waht is Investment

Nature of Investment

Investment is to set aside some financial resources (usually money) hoping that it will generate positive return in the future. Financial resources can be invested in financial assets such as stocks and bonds, or real assets such as properties or precious metals. Returns from investment come in two forms: capital gain and income. Captial gain refers to the price appreciation, selling the asset at a price higher than what you pay for it. Income refers to the cash inflow when the asset is in your possession. For example, you buy a stock at $10 a share on Jan. 1 and sell it for $12 at Dec. 31. The capital gain for this investment is two dollar. Also during the year, you receive a dividend of $0.5. The income from the investment is $0.5. The total return on this particalr investment for the year is $2.5 per share, or 25%.

Expected Return

One of the most misleading term in investment is "Expected Return". Expected return is the return an investor expects from an investment. It is calculated by multiplying potential outcomes by the probability of them occurring and then summing these results. The problem of this approach is that it assumes the investment can be replicated many many times and the returns are averaged. In reality, we only have the chance to invest in the same investment once or twice. And more often then not, investors don't get the expected return.

Investment Risk

Risk is uncertainty. Investment risk is the level of uncertainty of achieving the investor's expected return. The higher the uncertainty of the investment return, the higher the risk.

To most investors, investment risk is about loss. The higher the chance of a loss, the higher the risk. But the chance of a loss that will occur is only half of the story, the size or magnitude of the loss also matters. For example, when the jackpot of a lottery reaches $100 millions, many people would buy a ticket or two. They all know that the chance of winning the jackpot is next to impossible, but when they lose, they only lose a couple dollars. On the other hand, for a high-low dice game that requires a wage of $1,000, most people would think twice before placing the bet.

A popular metric of risk measurement in invesement is standard deviation of return. Standard deviation of return measures the average difference of actual returns fromthe expected return. If the standard deviation of return of an investment is small, and investor use the expected return as the target, the actual return should not be too far away from it. The investment is a safe investment. On the other hand, if the standard deviation of return is large, the actual return may be far away from the target, and the investment is risky.

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