If you’re looking to get started with investing, ‘capital’ is a word that you’ll see dotted across marketing materials for investment firms and in news stories related to the markets. Given how common it is, it’s surprising that so many people have only a fairly loose understanding of what it actually is.
So, what does ‘capital’ mean, and how does it relate to your money?
By definition, capital refers to wealth in the form of money or other assets. It is also commonly used to describe assets that are available in the form of investment. In economics, capital is both the result of production and a contributing factor to it. For example, machinery used to create products is capital, along with the products it creates. In economics, capital is an input in the production function.
In broad economic terms, capital represents anything from which a person might expect to accrue revenue, and this includes cash – though we will explain why equating the two is problematic. Capital is one of the fundamental tenets of capitalism as we know it.
For investors or savers, your capital is made of all of your assets together. Capital is not your income, or the amount you have available to spend, rather it is a measure of your overall wealth. It includes your pension, any property you might own, as well as your savings and investments.
The difference between cash and capital
While capital is a way of referring to money, there is a clear difference between capital and cash. Cash is the money you have available at a moment’s notice; it is what you use to buy coffee or the morning newspaper. This spending money is not something that will help you in the long-term, it caters for your day-to-day needs but is unlikely to appreciate in the future.
One way of looking at the difference between capital and cash is that cash is something you don’t invest, it’s something you don’t need. You can use any excess cash to invest, but when you do, you don’t have cash anymore, you have capital. If you needed to spend that capital, you would need to convert it back into cash.
For example, if you own a home, you don’t view that as cash, or even money, but it is part of your overall wealth. It is an asset in the same way as an investment is, you would need to sell it in order to be able to spend the value. And like an investment, you hope that the property will gain in value over time, but you buy it knowing that markets may not work in your favour.
Why could capital be at risk?
Cash is a constant; a pound coin is always a pound coin. However, the amount you can buy with that pound can change over time. Capital can suffer from fluctuations; the housing market can crash, and share prices can drop. Sometimes these drops can be to the extent that you lose the majority of your wealth.
This is why we advocate diversification at Moneyfarm, by investing in a range of assets you reduce your exposure to the volatility of any one capital investment. Any losses made in asset class or geography can be offset with gains made elsewhere, a central tenet of a lot of modern portfolio management theory.
This is why, when you see the phrase ‘capital is at risk’, it’s important to know that there are ways in which you can reduce that risk (though, of course, you cannot eradicate it completely).