What is an Investment?

Share:

It is often said that buying a home is an investment, and maybe that’s because in general home prices have appreciated over the last 80 years or so and people think that when you buy something and it goes up in price, that is an investment. Some people even say that a home is the single biggest investment that one will ever make in their lifetime. On twitter, I had an exchange with Larry White where, on a post of his, I commented “A home is not an investment any more than food is. A home provides housing. Food provides satiation of hunger. The only difference is how long they serve their purpose.” Larry White then replied by saying that “How long it provides for is indeed the whole difference when we distinguish investment (for next years and subsequent output) from current consumption. A house will provide services next year, while groceries won’t.” This is certainly a more sophisticated view on why a home is an investment, but it is still not quite right, and I will provide what I believe is a much better distinction. Now, I must say I only use this as an example, and that I do not know the full extent of Mr. White’s arguments and beliefs nor do I single him out, but he is a distinguished economist, and this comment may be taken as a brief introduction to his belief. He certainly seems to put forth the idea that a home *is* an investment. All of this begs a question which should be rigorously investigated; what exactly is an investment?

One generally sufficient and quick way to describe it, I first heard from George Gammon, where he maintains that an investment is “something that pays you to own it”. So, if a stock pays a dividend, if a bond pays interest, or if private ownership of a business delivers a share of income, then these can be called investments. The instance when a business is started and the investor is the owner, purchases the capital goods himself, and goes into production can be called a direct investment, or active investment. Buying a stock or a bond can be called an indirect investment, or passive investment, though these distinctions are slightly less important to the overall point of this essay, however relevant to the wording used to describe the ideas. The crucial part to this perspective is that an income is generated. This is a different kind of yield than the yield from a house that provides services year after year, as Mr. White mentioned. It is also quite a different type of gain than a speculation, where the goal is to make a purchase at one price and a sale at a greater price, realizing a capital gain. A stock will deliver quarterly dividends for as long as the company can continue paying them out and a bond regular interest payments until the bond matures; both so long as the underlying income producing assets that were bought with the stock or bond proceeds continue to perform. This point aside from the government’s bonds, which do not pay interest based on productive investment, but rather based on its ability to tax. This would be a faux investment. It masquerades as one and may even be perceived as one by the investor, yet it does not fit the bill.

An investment generally returns the capital back to you over time or at least attempts to. If the investment fails, then this is still an investment, albeit not a successful one. There is usually an agreed upon rate on invested capital that the investor will receive. Additionally, an exchange takes place after the investment if the investment is not direct. In an indirect investment, the entrepreneur does not just hold the money, but rather spends it on capital goods, which can generate an income, hopefully greater than necessary expenses, so that the investor’s return comes from the net sales of the product of the capital goods. Say, someone invests money into a company’s bonds. The company purchases capital goods and raw materials with the proceeds, engages in production, sells the finished products, and returns to the investor a portion of that profit, usually at an agreed upon rate, or in proportion of capital ownership.

So now we can ask, is a home an investment? Well, it can be sometimes, but it depends on the purpose of the purchase. If the buyer rents the home out, and it delivers them an income, then yes, the home is an investment property. The house may be constructed, remodeled, updated, upkept, or transformed in some way that delivers value to the tenant, as is expressed by the tenant’s action in the market to rent rather than buy. The landlord’s production was everything involved in making the house inhabitable and by presenting to the rental market a house available for rent. But if someone simply buys a home to live in it, that is not an investment. It could be argued that the home produces a yield by being a place to live over time, which was the argument put forth by Larry White. Because this home will deliver services of shelter and safety year after year, then Mr. White would call it an investment. I am of the opinion that this is a different type of yield. I would like to coin a term for it, called “yield on consumption” to describe this type of yield and more specifically, where the yield comes from. Yield on consumption is what is derived from the purchase of something for one’s own consumption or use, and this would be an alternative to “yield on production”, which is what is derived from an investment. In place of yield on consumption, it could also be called “personal yield” and in place of yield on production, it could be called “financial yield”, and I encourage the reader to favor whichever terms give most clarity to the concept.

If it were true that these different types of yields were the same thing, then in that case, everything would be an investment on a spectrum of time. One could buy a package of 12 steaks, cook them all at once, and then claim that this was an investment, because now the steaks are delivering a yield to him for the next 11 days (he eats one the night he cooks them). Even the most highly consumable type of good becomes confused with fitting the definition of an investment if we don’t make the distinction between the different types of yields. If an objection is made that this is ridiculous and that the steaks are not delivering a yield because it is such a short time period, then I beg the question, where is the line drawn? At 11 days? At 3 months? 5 years? 30 years? Who is to know and how do they decide? What if someone buys a metal fork, and uses it for many, many years? It was not really “consumed” when it was bought, and it delivered the services of an eating utensil thousands of times over the years. Would the same people who maintain that a home is an investment, call a simple metal fork an investment? After all, they both are capable of delivering services over the course of many years. If that view is maintained, then there is a real problem with the definition of an investment.

Finally, to try and define what an investment really is. A working definition of an investment might be something like “the purchase of an asset, for which the proceeds are honestly intended to be the funding for a productive enterprise so that it delivers a yield to the investor, known as a yield on production.” This fits for an indirect investment, but does not for a direct investment, as there are no “proceeds” with a direct investment. When the investor is also the entrepreneur employing the capital, he is already in possession of what are the proceeds in the previous definition, so one can call a direct investment “the purchase of capital goods, with the intent to enter into production, so that an income may be delivered back to the owner(s) of said capital goods, known as a yield on production.”

One final point I want to make, in response to Mr. White’s comment about distinguishing investment from consumption. Investment is really just current consumption of resources with the goal of future production of resources in excess value of said consumption. When a business begins, it requires various resources to begin operations. A building may have to be built, and the builders have to be paid since they have to eat for sustenance while the building is being constructed. There are all kinds of upfront, immediate, and recurring costs involved in business operations before any sales are ever made. And if the business fails, as in it is never able to turn a profit, then all that is occurring is consumption. The business may still produce something in that instance, but it is a net consumer. Maybe that can be the definition of a failed investment, “an investment that results in net consumption after the attempt at running a productive enterprise is finally accepted as a defeat”.