An investor is an individual (or entity) that takes a risk in order to realize future benefits. Such benefits are referred to as the "return" on investment. Often, the term "investor" is used in the context of business and finance, where it refers to someone who allocates capital in "investments" with the expectation that the investment will become more valuable in the future. The defining quality of an investor is the assumption of risk; in investing, an investor invariably faces the possibility of losing some or all of her initial investment. Without risk-taking, there is no investing. According to the famous investor Warren Buffet, investing is the "laying out money now to get more money back in the future." Accordingly, an investor is an individual or entity that does the "laying out" of money.
Investors, as commonly understood, may allocate capital in various financial instruments, including, but not limited to, equity in the form of shares of a company, debt securities in the form of corporate or government bonds, real estate, and derivatives (e.g., options, futures, and forwards). An investor that directly allocates capital to a business–through debt financing or by purchasing equity–invests in the primary market. By contrast, an investor that purchases company shares from a public exchange, such as NASDAQ, is an investor in the secondary market. Shareholders are investors that own stock in a company; creditors are investors that lend capital to a company. These terms matter because they carry different legal rights, particularly in the context of bankruptcy.
In financial regulatory schemes, the term "investor" generally falls under two bucket categories–the "retail investor" and the "institutional investor." Retail investors are individual investors and households that hold relatively small stakes in particular securities. By contrast, institutional investors are professional investors, such as banks, insurance companies, private wealth funds, mutual funds, among others, that maintain large portfolios of investments in a variety of assets. In terms of scale, “retail investor market participation, though declining relative to that of institutions, is growing on an absolute basis. Thus, individuals represent an important source of capital for U.S. corporations.”
Financial regulation is premised on the distinction between retail and institutional investors; retail investors are seen as vulnerable and unsophisticated actors that deserve consumer protection. In contrast, institutional investors are sophisticated and rationale actors that benefit most from laissez-faire markets. Indeed, when Congress enacted the Securities and Exchange Act of 1934 in the wake of the Great Depression, the focus was on the need to protect individual investors from fraud. The philosophy of caveat emptor was not Congress' guiding principle. Indeed as the Supreme Court stated in SEC v. Capital Gains Research Bureau, Inc., "[a] fundamental purpose, common to these [securities and exchange] statutes, was to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry."
Institutional investors are specially recognized by the SEC in Rule 501 of Regulation D. This regulation creates a subset of investors, termed "accredited investors," defined, in part, as "[a]ny natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000" or "who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year." Whereas stringent requirements normally apply to investment offerings to the general public, private investment offerings to accredited investors avoid such regulation. SEC justifies this relative "hands-off" approach by pointing to accredited investors' wealth, sophistication, and overall financial acumen. Unlike their retail counterparts, accredited investors can "fend for themselves," as the Supreme Court put it in SEC v. Ralston Purina Co. In Ralston, a corporation offered shares of its stock to a number of its "key employees." Still, it failed to comply with the registration requirements of the Securities Act of 1933 by disclosing information to its employee investors.
Investors can be described as either "passive" or "active," depending on the investor's ownership style. Passive investors generally hold investments for a long duration without challenging the directors of corporations. By contrast, activist investors are aggressive in their attempt to influence and affect the business operations in which they invest, often seeking to reap large returns on a short timeframe. Passive investors are silent when a company does something they disagree with, whereas active investors take measures to influence corporate boards, executives, and other investors. Sometimes these confrontations are private engagements; at other times, they are public through litigation, proxy-fights, and public relations campaigns.
While many investors are speculators, they are not gamblers. Gambling is speculation based on random outcomes. By contrast, investing is speculation based on empirical measurements used to calculate a given asset's "investment risk." Investors may place their money at risk on a given investment, but they often do so by calculating the given risk. For instance, an equity investor may choose to analyze a company's financial statements to assess whether it's future promises profits and dividends. For an investor, the risk is a matter of degree. A relatively safe investment, such as Treasury Bills, provides modest returns and low risk. A riskier investment, such as distressed debt, carries higher yields but carries the risk of losing an investor's entire investment. It is the job of an investor to decide which investments are worth the risk. (Furthermore, an investor is not an arbitrageur since an arbitrageur's profit is generated without risk and without allocating investment capital).
Advances in behavioral psychology have improved our understanding of how "investors" think (and how governments should regulate). This research counters the assumption that investors are rational actors capable of accurately pricing the risks and rewards of an investment. No human is a perfectly rational decision-maker, argues these researchers; therefore, no investor is perfectly able to maximize individual utility in the marketplace. In 2012, the Securities and Exchange Commission found that "American investors lack basic financial literacy" and the means to protect themselves from securities fraud. One law review article notes that “[m]ounting evidence demonstrates that retail investors make predictable, costly mistakes.”
Recent history supports the conclusion that investors are often irrational. In the lead up to the 2008-09 Great Financial Crisis, investors purchased homes they could not afford with mortgages they did not understand. And during the dot-com boom, investors placed bets on companies largely based on the company's name. In short, investors are influenced by emotions, biases, heuristics, and framing effects that often lead to inefficient trading and poor investment decisions. Perhaps Isaac Newton best describes the cognitive limitations of the investor when he remarked, "I can calculate the motion of heavenly bodies but not the madness of people." Indeed, Newton suffered major investment losses following the South China Sea bubble of 1720. Even so, a growing body of research suggests that investors are irrational, but predictably so; investor behavior, while irrational, is systematic and can be modeled.
[Last updated in July of 2020 by the Wex Definitions Team]
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