Definition of InvestmentFrom our discussion, we can specify a formal definition of investment. Specifically, an investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for
(1) the time the funds are committed,
(2) the expected rate of inflation, and
(3) the uncertainty of the future payments.
The “investor” can be an individual, a government, a pension fund, or a corporation. Similarly, this definition includes all types of investments, including investments by corporations in plant and equipment and investments by individuals in stocks, bonds, commodities, or real estate. This text emphasizes investments by individual investors. In all cases, the investor is trading a known dollar amount today for some expected future stream of payments that will be greater than the current outlay. At this point, we have answered the questions about why people invest and what they want from their investments. They invest to earn a return from savings due to their deferred consumption. They want a rate of return that compensates them for the time, the expected rate of inflation, and the uncertainty of the return. This return, the investor’s required rate of return , is discussed throughout this book. A central question of this book is how investors select investments that will give them their required rates of return.
This value will always be zero or greater—that is,it can never be a negative value. A value greater than1.0 reflects an increase in your wealth, which means that you received a positive rate of return during the period. A value less than 1.0 means that you suffered a decline in wealth, which indicates that you had a negative return during the period. An HPR of zero indicates that you lost all your money. Although HPR helps us express the change in value of an investment, investors generally evaluate returns in percentage terms on an annual basis. This conversion to annual percentage rates makes it easier to directly compare alternative investments that have markedly different character-is tics. The first step in converting an HPR to an annual percentage rate is to derive a percentage return, referred to as the holding period yield (HPY). The HPY is equal to the HPR minus 1