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 (remember X-M in the circular flow), 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 Study of Scarcity

“…you can’t always get what you want.”

 

The Rolling Stones may have said it in the most entertaining way in the late ’60s, but economists have been saying it for centuries,

Economics is the science, or study, of choice.

The pillars of modern mainstream economics include the concepts of scarcity, opportunity cost, self-interest, specialisation, market dynamics and market failure – all of which are relevant to an understanding of the reasons to invest and why property provides a relatively safe and predictable way to do so.

The fundamental problem we all face is scarcity, and it applies to us collectively and as individuals.

While Australia is a prosperous, naturally endowed nation, our resources are finite. To be considered useful, resources need to be known and accessible. Only then can they be regarded as one of the four factors of production – land, labour, capital and enterprise.

For example, Australia has an abundance of land, but most of it is arid desert.

The cost of development and infrastructure provision to make a desert inhabitable would be prohibitive.

 

 

 

Fixer Upper

If you have ever watched any of the popular ‘fixer-upper shows’ coming out of the US midwest then like me, you are probably amazed (even in AUD adjusted terms) at what they get for their money!

But the explanation is simple – while our land areas are not dissimilar, theirs is very different topography, and it allows them to build right across the country – land is therefore not a scarce commodity.

Not so in Australia – the vast majority of us are confined to the edges (approximately 67%) and therefore, developed, useable, infrastructure connected and supported land is scarce and as a result, far more valuable.

It’s textbook supply and demand theory in practice.

 

Typically, your income is the resource you have at your disposal to satisfy your wants and needs.

Income is the return to the factors of production. There are four types of factor income:

Most of us will earn a wage or salary in return for labour,

but we also have the opportunity to

earn income in other ways too.

 

Once you have earned your income, there are only three things you can do with it; you can spend it, you can save it and, pay taxes.

There are no other alternatives!

Most people have the tax taken out automatically before they get to make any choices about consuming or saving. What you have left is disposable income.

Disposable Income = Gross Income – Taxation

Our predicament compels us to make choices. As rational human beings, it’s assumed that we all try to allocate our scarce resources to our competing needs and wants to maximise our satisfaction.

We are all economists!

In the next section, we will examine how we make those choices.

How do we as a nation and as individuals

increase our standard of living

by reducing scarcity and

enhancing our choices in life?