Asset Classes

Assets can be broadly classified

as either

 

DEFENSIVE or GROWTH

We have seen so far that scarcity requires us to make choices about the satisfaction of the competing needs we have in life. Increases in productive capacity imply a more satisfactory answer to the economic problem. More capacity means more employment, more income and more tax revenue.

To increase potential satisfaction, or make the economic pie larger, it is necessary to devote some resources to investment.

(*Implies a more satisfactory answer because it very much depends on how the additional income/goods and services are distributed but that is the realm of normative economics and a different discussion!)

In a specialized economy, we have our income to satisfy our needs first and then wants, via discretionary spending.

Once you have paid tax, you then have the choice to either spend or save your disposable income.

If you are in a position to save and decide to invest, you then have to determine how to make your money work for you.

There are four main asset classes.

They can be broadly classified as either DEFENSIVE or GROWTH assets.

Defensive assets focus on generating an income. There is minimal risk involved, and so the returns are very modest. They are appropriate for those who are very conservative and are not in a position to risk losing any of their capital, e.g. the elderly. Examples are Cash and Fixed Interest securities.

Assets can be financial, paper assets such as bank accounts or shares (pieces of paper that ensure ownership). Assets can also be classed as real, or tangible such as property.

DEFENSIVE ASSETS:

  1. CASH – deposits in the bank that earns interest, typically at a base rate. The investment is highly liquid, that is you can access it at any time. Therefore the financial aggregators, the banks and financial institutions generally, have less certainty about what they can invest the money in and for how long and so are only prepared to pay lower interest. Depending on the time value of money, influenced by the inflation rate, cash in the bank may lose value over time as buying power diminishes.

 

2. FIXED INTEREST – Fixed interest assets are loans to companies (debentures) and government (bonds). They are similarly low risk, though slightly more risky than cash and the returns are a little higher since they are for a fixed term, giving the holder of the security more certainty. Because the term is set (anywhere generally from 1-5 years) these are less liquid assets.

GROWTH ASSETS

Growth assets focus not only on generating an income but also on capital growth, or an increase in the value of the asset over time. The trade-off is that the investor needs to be prepared to ride out any volatility in the market or at worst, suffer a capital loss. Time in the market is more important than timing.

3. PROPERTY – investment in property either indirectly or directly is deemed a growth asset as it not only generates income but also over time, capital gain. Bricks and mortar is a tangible, real asset and isn’t subject to management performance, the returns are contracted in a lease agreement, and the government provides substantial incentives to encourage the supply of and demand for housing. Real estate as an investment lacks liquidity, but capital doesn’t tend to be at risk- volatility in house prices isn’t usually pronounced. There are relatively large entry and exit costs and the asset class suffers the disadvantage of indivisibility.

4. SHARES – Shares can be very profitable, but they carry the highest risk of this asset class. Shares are proportional ownership in a company, and as such are subject to the performance of the management, this may be excellent, or it may be lacking. Your investment as a shareholder may be at the mercy of personality, individual talent or outright bad behaviour!

Their value is dependent on the performance of the company in the broader context of the economy, exogenous influences like the demand for our goods and services internationally and the management style of individual CEOs and Directors.

Shares are an asset class that provides low-cost entry and liquidity. Given the ease at which shares can be sold, they provide the investor with an opportunity to realize gains progressively or cash in should circumstances change.

However, given the ease of entry and exit, they are also more volatile – investor expectations can become a self-fulfilling prophecy.

In a global economy, international shares are riskier still as they are subject to currency risk – fluctuations in either currency may impact the returns.

Example: If an Australian based investor is expecting USD 10,000 as a return on investment, it may translate into AUD 20,000 if the exchange rate is USD 1 = AUD 2,

BUT if the AUD appreciates to equal to the USD, the return in AUD will be reduced to $10,000. ($1AUD=$1USD)

PROFIT is the return to RISK. The more risk you are prepared to take, higher are the potential returns. Any investment choice needs to be evaluated, taking into account your particular circumstances and stage on the income/life cycle.

Diversification is also a golden rule of investment, that is, not putting all your eggs in one basket’!

Diversifying spreads the risk and helps smooth out volatility across a portfolio.

Different people also have different appetites for risk.

 

 

 

 

 

 

The Importance of Investment

“Someone is sitting under a tree today because

 

someone planted a seed a long time ago.”

Warren Buffett

 

To increase the productive capacity of the economy and allow us more choices, requires that we refrain from consuming all resources now and invest for the future.

Resources- land, labour, capital and enterprise – are dedicated to future production. Turning iron ore into machinery rather than cars, educating the innovators of tomorrow, and incentivising the use of new technology, are some examples of ways as a nation we invest in the future.

Some decisions or allocation of budget resources may pay dividends quickly; others take time, such as grants to research facilities or revising the school curriculum to include coding in the kindergarten school curriculum!

The funds available to increase the productive capacity of the economy (via investment) primarily come from the pool of national savings contributed by both by the private sector (households) and the public sector (government) via the financial sector.

Remember, to have more options and less scarcity; we need to make the economic ‘pie’ grow or, shift the production possibility curve out to the right.

Likewise for us households!

Another way of thinking about the size of the economy is via the simple circular flow of income model that looks at injections into the economy vs the leakages.

Think of it as a large above ground swimming pool. The more water that is pumped in (injections), the higher the level of water in the pool and more people can get in and get wet. Spring a leak and the water level falls meaning some swimmers need to get out. (= unemployment)

Injections are consumption expenditure (C), investment expenditure (I), government expenditure (G) and the sale of exports (X).

Leakages are saving (S), tax (T) and imports (M)

If injections are > leakages, the economy will grow.

If leakages are > injections, the economy will contract.

 

 

Consumption is the most significant contributor to demand in the economy. Maintaining consistent consumption is vital to keep people employed.

Regulating the level of consumption in the economy is one of the primary responsibilities and targets of economic management. Variations in consumption, both increases (in times of prosperity and strong business and consumer confidence) and decreases when the opposite conditions prevail, has significant impacts on the level of income, output, and employment in the economy.

Via the multiplier effect, any change in consumption has a ripple effect throughout the economy.

For example,  the government implemented a stimulus package to support consumption and businesses in the wake of the exogenous shock to our economy that has necessitated social distancing to combat COVID-19.

One of the cash injections was in the form of three payments to Pensioners. Why? Because most pensioners are living on minimum incomes and so they are extremely likely to need to spend, rather than save the bonus payment.

Their marginal propensity to consume (MPC) is high.

The MPC is a measure of how likely a recipient of funds is to spend an extra (or marginal) dollar they receive.

If the MPC = 0.8 recipients will  spend 80 cents and save 20 cents

A $10 million injection into the economy, in this case, will result in a much more substantial $50 million stimulus to the economy.

Of course, this simple example assumes the recipients of their spending will have the same MPC. It may be higher or lower; nonetheless, the concept is evident. A carefully targeted injection into the economy will have a reasonably predictable compounded effect on consumption, income, and employment.

An understanding of the power of

the multiplier

is fundamental to understand the significance

of the housing market

 and why governments

provide incentives

to invest in bricks and mortar and are

very unlikely to ever remove those incentives

 

 

 

 

“Home Building Packs a Punch in Job Creation Stakes”

A new report from the  National Housing Finance and Investment Corporation reinforces the view that  “the residential construction sector punches well above its weight as an economic multiplier” and “understanding how residential construction activity may affect jobs and flow through to the broader economy is increasingly important… The Urban Developer June 19, 2020

 

 

But what if in times of uncertainty households save instead of spending?

All is not lost, nor is the stimulus ineffective.

They provide funds via financial institutions for firms to invest and increase their productive capacity. Provided you don’t stash your savings under the bed, (a leakage from the system) you are making it possible for firms to borrow and invest and build the capacity of the economy.

That constitutes a passive investment in the economy and our future collective welfare,

BUT

you can also do the same,

individually and proactively!

 

We can invest in our own and our family’s future by devoting some of our resources (time, income, assets, efforts and skill) to education and training to improve our earning capacity or saving to directly and deliberately invest in creating future wealth.