What IS An Investment?

Just because you spend money on something valuable doesn’t mean you’ve made an investment.

We hear the word investment everywhere.

• A home is an investment.

• A car is an investment.

• A college education is an investment.

• A wedding is an investment.

• A new kitchen is an investment.

Even an advertisement for wedding liability insurance recently began with the statement:

“Your wedding is one of life’s biggest investments.”

But is it?

A wedding may be one of the most important events in someone’s life. It may be worth every dollar spent on it. Protecting that expenditure against certain financial risks may also be prudent.

But none of those things makes the wedding itself an investment.

We have gradually turned investment into a synonym for anything worthwhile that requires money.

Financially, those are very different concepts.

An Expense Can Be Worthwhile Without Being an Investment

Suppose you purchase a car for $50,000.

The automobile requires an initial cash outlay. It requires insurance, registration, fuel, maintenance and repairs. Eventually, it will probably be worth substantially less than you paid for it.

On those facts alone, the automobile isn’t an investment.

Yet the automobile may provide enormous economic utility.

It allows you to travel farther than you could walk. It may dramatically reduce the time required to get to work compared with public transportation. It may allow you to accept employment that would otherwise be inaccessible.

A contractor may use a truck to transport tools and equipment necessary to earn income. A salesperson may use a vehicle to reach customers. A delivery business may use vehicles directly in producing revenue.

The vehicle can therefore enable economic activity.

That is different from saying the vehicle itself is necessarily an investment.

In fact, the same physical object can serve very different economic purposes depending upon how it is used. A car purchased primarily for personal transportation is different economically from a vehicle acquired by a rental-car company specifically to generate revenue.

That distinction matters.

Your Home Illustrates the Problem Even Better

People routinely say:

“Your home is the biggest investment you’ll ever make.”

Maybe.

A residence is certainly an asset. It has economic value and can appreciate.

But an asset and an investment are not necessarily the same thing.

Your residence also consumes capital.

There may be mortgage payments, property taxes, insurance, maintenance, repairs, improvements, utilities and transaction costs. Even after the mortgage has been paid off, many of those expenses continue.

Suppose a property purchased for $500,000 eventually becomes worth $800,000. You have experienced $300,000 of appreciation before considering all of the costs associated with owning it.

But that $300,000 isn’t automatically spendable cash.

You cannot buy groceries with the increased value of your kitchen.

To make that increased value available for another purpose, you generally have to monetize the asset—perhaps by selling it, borrowing against it, renting some or all of it, or otherwise converting its value into usable capital.

None of this means that owning a home is a poor financial decision. Homeownership can provide tremendous financial and nonfinancial benefits.

It simply means we should distinguish among:

an asset, an investment, an expense and an economically productive tool.

They aren’t necessarily the same thing.

What, Then, Is an Investment?

I prefer a more demanding definition:

An investment is an allocation of capital made with the reasonable expectation that it will produce future economic value exceeding the capital committed to it.

That economic return might come from:

• cash flow or income;

• appreciation that can eventually be realized;

• increased productive capacity;

• reduced future capital requirements; or

• some combination of these.

This definition also forces us to recognize something frequently ignored:

An investment should be evaluated by what comes back—not merely by what goes in.

Spending $100,000 doesn’t make something a $100,000 investment.

It means you allocated $100,000 of capital.

The next question should be:

What does that $100,000 economically produce?

Investments and Securities Aren’t the Same Thing

When people hear the word investment, they often immediately think of stocks, bonds, mutual funds or other securities.

But securities are a type of investment; not all investments are securities.

A security is a particular kind of financial instrument representing an ownership interest, creditor relationship or other financial interest subject to securities laws and regulation.

Capital, however, can be invested in many things that aren’t securities.

• A privately owned operating business may be an investment.

• Income-producing real estate may be an investment.

• Equipment acquired to produce revenue may be an investment.

• Intellectual property may be an investment.

• Capital improvements that increase productive capacity may represent an investment.

The broader economic question isn’t simply:

“Is this a security?”

It is:

“Am I committing capital with the reasonable expectation that it will produce additional economic value?”

Investment is a broader economic concept. Securities are a particular category of financial instruments.

The two terms should not be treated as interchangeable.

Assets Aren’t Necessarily Investments

This distinction becomes especially important in financial planning.

Imagine two people who each have a $2 million net worth.

• One owns a $1.5 million residence and has $500,000 of financial assets.

• The other owns a $500,000 residence and has $1.5 million of income-producing financial assets.

On a net-worth statement, they are both worth $2 million.

Economically, however, they may occupy very different positions.

The first person may be asset rich but cash-flow poor.

The second may have substantially more capital capable of producing income.

That doesn’t mean the first person’s house was a mistake. It doesn’t mean the second person’s financial assets are necessarily good investments.

It means something much simpler:

Net worth tells us what someone owns. It doesn’t necessarily tell us what those assets economically do.

And that distinction becomes increasingly important when someone needs their accumulated assets to provide cash flow.

Some Expenditures Create Indirect Returns

This is where the definition requires some nuance.

Education is a good example.

Tuition doesn’t ordinarily generate cash flow. A diploma doesn’t send you a dividend check.

But education can increase a person’s productive capacity and lifetime earning potential.

If someone spends $50,000 acquiring training that enables an additional $30,000 of annual income for the next 25 years, there is a legitimate economic argument that the education represented an investment in human capital.

But even here, we shouldn’t simply declare:

“Education is always an investment.”

The appropriate question remains:

What did the expenditure enable the person to produce that they could not otherwise have produced?

The return matters.

The same reasoning applies to a business owner purchasing equipment, technology or professional training. The expenditure itself doesn’t magically become an investment simply because it was made for a business.

We still need to ask what economic value it is expected to produce.

Protection Isn’t Necessarily an Investment Either

Insurance presents another useful example.

We routinely hear insurance described as an investment.

Most insurance isn’t.

Insurance is primarily a risk-transfer mechanism.

You deliberately spend money to transfer a potentially much larger financial consequence to an insurance company.

Your homeowners insurance doesn’t become a bad financial decision because your house didn’t burn down.

Your liability coverage wasn’t wasted because nobody sued you.

And wedding liability insurance doesn’t need to be called an “investment” to have value.

Protection has economic value without pretending it is an investment.

That is an important concept because financial planning isn’t exclusively about maximizing investment returns.

• Some dollars are allocated to create wealth.

• Some are allocated to preserve wealth.

• Some provide liquidity.

• Some increase productive capacity.

• Some purchase utility or convenience.

• Some transfer risk.

And some simply purchase things and experiences we enjoy.

All of those can be perfectly legitimate uses of money.

They simply aren’t the same uses of money.

The Danger of Calling Everything an Investment

The problem isn’t that people buy houses, automobiles, weddings, vacations or other things they value.

The problem begins when we use the word investment to give an expenditure financial characteristics it doesn’t actually possess.

“This is an investment” sounds considerably more financially responsible than:

“I want this, I value it, and I’ve decided it is worth spending the money.”

But the second statement may actually represent clearer financial thinking.

Not every dollar needs to earn a financial return.

• You are allowed to spend money because something makes your life better.

• You are allowed to purchase convenience.

• You are allowed to purchase experiences.

• You are allowed to purchase protection.

• You are allowed to purchase beautiful things.

We don’t need to redefine all of them as investments to justify owning them.

Ask a Better Question

Whenever someone tells you that something is an investment, ask three questions:

1. What is the expected economic return, and how will I receive it?

2. What additional capital will I have to commit along the way?

3. What would happen if I allocated that same capital somewhere else?

Those questions begin separating the purchase price from the economic consequence of the decision.

They also introduce something that should be part of virtually every capital-allocation decision: opportunity cost.

A dollar can only be allocated once.

The question therefore isn’t merely whether something has value.

It is whether the value you expect to receive justifies allocating your limited capital there rather than somewhere else.

What Is Your Money Actually Doing?

Perhaps the simplest way to think about all of this is:

Asset ≠ Investment ≠ Expense ≠ Protection ≠ Productive Tool

One item can sometimes occupy more than one category. Its purpose can also change over time.

The important thing is to understand what job you are asking your money to perform.

• If you’re spending it for enjoyment, call it an expenditure.

• If you’re purchasing something of lasting value, recognize it as an asset.

• If you’re transferring financial risk, recognize the value of protection.

• If something allows you to become more economically productive, recognize that utility.

• And when you allocate capital with a reasonable expectation that it will produce greater future economic value, then you can appropriately evaluate it as an investment.

There is nothing wrong with any of these uses of money.

But calling something an investment doesn’t make it one.

What matters is what the capital actually does after you allocate it.