Assets can be broadly classified
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.
- 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 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.