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 implies a more satisfactory answer to the economic problem. More capacity means more employment, more income and more tax revenue. To increase capacity, 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 income to satisfy our needs first and then wants via discretionary spending.
Once you have paid tax you have the option to either spend or save your disposable income.
If you are able to save and decide to invest you then have to decide how to make your money work for you.
There are four main asset classes. They can be broadly classified as DEFENSIVE or GROWTH assets.
Defensive assets focus on generating an income. There is minimal risk involved and so the returns are very modest. These are for those who are very conservative and are not in a position to risk losing any of their capital, eg the elderly. Examples are Cash and Fixed Interest securities.
Assets can be financial, paper assets such as bank accounts or shares. These are pieces of paper that ensure ownership.
Assets can also be classed as real, or tangible such as property.
- CASH – deposits in the bank that earn interest, typically at a low 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 a 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 due to the fact that they are for a fixed term, giving the holder of the security more certainty. Because the term is fixed (anywhere normally 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 suffer a capital loss. Time in the market is more important than timing.
3. PROPERTY – investment in property either indirectly or directly is considered 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 considerable incentives or ‘negative taxes’ to encourage the supply of housing.
4. SHARES – when you buy shares you buy part ownership in a company. Shares can be very profitable but they carry the highest risk of these asset classes. Their value is dependent on the performance of the company in the wider 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 performance of individual CEO’s and Directors.
PROFIT is the return to RISK. The more risk you are prepared to take, potentially higher are the returns. Any investment choice needs to be weighed up taking into account your particular circumstances and stage on the income/life cycle.
Diversification is also a golden rue of investment, that is, not putting “all your eggs in one basket”!
Different people also have different appetites for risk.