Thursday, October 14, 2010

What is investment?

It is paying a lump sum to own the claim of future cash flow.

If the cash flow is guaranteed, such as a treasury bond, the only question you need to ask yourself is whether the discount rate is reasonable. A higher discount rate will give you a lower lump sum value. If you have paid a larger lump sum for the cash flow you now owned, then you lost your capital.

Other than the treasury the future cash flow is not guaranteed. If you lent your money to someone and he can no longer afford to pay his promise, then you lost your capital. To avoid lost of capital you need to make sure that someone you lent to have enough income to pay his promise. Or you have enough collateral to recoup your lose.

When you buy a company or own stocks you are paying a lump sum to own the company’s future cash flow. But that future cash flow is even more uncertain than assessing a borrower’s ability to pay his promise. Although the company has stable business today, how do we know it will have stable business years and decades down the road? Technology changes and so do demand: people in the past used telegraph and telex to communicate. Back then those were new technology that greatly improved the speed of communication and were in high demand. They are no longer used today. Another example is the passenger train in the 19th century – a big progress on people transportation from the era of horse and carriage. But later automobile and airplane came.

Whatever you invest in, the fundamental question is simple. Ask yourself: Is this lump sum I paid today a reasonable price for that future cash flow? Answering this question isn’t easy. It involves assessing two things: First, is the discount rate correct? Second, is the future cash flow reliable?

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