Till now we have seen what are assets and liabilities. In this post, we are going to understand investing and the terms associated with it. So let’s get started.
What is investing?
Investing by standard definition is the act of allocating resources to generate returns. Allocating resources without the aim of generating a return is charity. So irrespective of which instrument someone invests in the aim is to always make a return if he/she is investing. We all invest throughout our life with or without realizing it. The most common form of investment that all the classes of society do is education whether it be taught or self-education.
Now we know what is investing. But how to evaluate an investment? For this, we need to understand some important terms associated with investing.
Returns
If you have ever invested in anything the first thing which you would have evaluated or at least seen would be the returns or the past returns. It is the inherent nature of humans to pay for something if it provides value. This value is the return on the asset when investing. This return can be qualitative or quantitative. That is it appreciates, provides cashflow, or adds to your social image which in turn can help you unlock bigger opportunities.
Now there are two more terms that are commonly used with return, and they are Return on Equity (ROE) and Return on Investment (ROI).
Risk
The next term is Risk. So what is a risk? Risk is the possibility of loss, it can be loss of capital, life, or any other value. In investing risk is the loss of capital or time a person has invested. Why time? Because there is something called an opportunity cost associated with every decision an individual takes.
So suppose you have decided to allocate certain capital and time for a particular asset to perform and generate returns and it doesn’t generate returns. Now you have not only not generated returns but also lost the opportunity to have used up that capital elsewhere which could have given a better return.
Usually for a sensible investment risk and return are related.
Cash Flow
An asset can provide value in three forms either through appreciation, cash flow, or adding to your image. One metric for measuring the returns of an asset is to calculate the cash flow it provides. Cash flow as the name suggests is the flow of cash in and out of any asset. For people to make positive returns the cash flow should be net positive, that is the net inflow from the cashflow-producing asset should be more than the net outflow of the
Intrinsic Value
Intrinsic value represents what an asset is truly worth, the intrinsic value can be calculated in different ways such as through cash flow, qualitative and quantitative methods, etc.
Capital Gains
Till now the terms we have discussed are terms that are assessed before buying an asset. Capital Gains come into the picture when the asset is to be liquidated. There are two types of capital gains namely LTCG and STCG.
LTCG stands for Long-term Capital Gains. it is the capital gains accumulated over the long term. Now long term can be different according to different regulators for different asset classes. For India 3 years or more is considered long-term for equity markets.
STCG stands for Short-term Capital Gains, that is the gains accumulated in the short term. If the time period between buying and liquidating equity is less than 3 years then it is considered short-term.
Dividend
The dividend is a business deciding to distribute some of the profits to its shareholders instead of investing it in its own business or reinvesting it elsewhere. Distributing dividends means that either the company has excess cash or doesn’t currently have any opportunity to use that cash.
Tax
Tax in simple words is the cut you pay to the government for developing infrastructure and bringing in businesses which in turn generate employment and improve the quality of life. So where does the government take this cut from? It can take this cut in direct or indirect form, that is it can be direct such as income and capital gains tax or tax on consumables.
Yes, you read it right capital gains discussed earlier are taxed. However, the 2 types of capital gains, LTCG and STCG are taxed at different rates.
Inflation
Now this is a tricky term. Inflation refers to a decrease in the value of money over time, that is the decrease in purchasing power of the money or increase in the value of goods and services. So how is the inflation calculated?
It is calculated as the change in the average price of a basket of selected goods and services in a year. These baskets are of two types namely the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
This is all for this post. Comment your thoughts below. Don’t forget to follow my Facebook and Instagram pages. See you all in the next post, till then keep learning.