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Its-YOUR-money looks at Types of Investment

Remember, when we talk about investing, we mean using our money to buy an asset.
An asset is simply something that has a value, and here we can make two important distinctions, between real assets and financial assets.

Real assets

As the name suggests, real assets are real – they exist. We can touch them, weigh them, live in them, drive them, and even eat them or drink them if it comes to the crunch! The investment value of real assets is in some way connected with their usefulness. They are desirable because of what they are or where they are. The scarcer and more durable the asset, the greater the investment value is likely to be. There is no point buying an asset as an investment if it is likely to fall apart by the time we want to change it back into cash. Most consumer products (vehicles, appliances, boats, clothes) are generally regarded as ‘wasting’ or ‘depreciating’ assets – their value diminishes with age and use.

Real investment assets tend to be land and property (in the US property is referred to as ‘real estate’), precious stones and metals, antiques and works of art, and maybe fine wines. Commodities are real assets too (oil and gas, minerals and foodstuffs for example). Whilst they are not usually of direct interest to most private investors (what am I going to do with a few hundred barrels of crude oil?), we will discuss commodities in relation to derivatives later in this site.

Financial assets

In contrast to real assets, which have intrinsic value, the value of financial assets is connected with the rights that they give to the owner. The asset itself is usually a piece of paper or a record in a computer file. A banknote is a financial asset: it’s just a piece of paper with some printing on it, and its only value lies in the rights it gives the person who has it in their possession. It’s a form of promissory note: the Bank of England promises to pay the bearer the sum of… We never need to take it to the Bank of England (I sometimes wonder what would happen if we did) because everyone believes the promise.

A share in a company is a financial asset that gives the owner (you don’t actually need a piece of paper – your name on the share register is usually enough) the right to part of the real and financial assets of the business.

Financial assets were invented because people found it difficult to live by trading real assets and skills over time and distance. It’s real assets that we really need (we can’t live by eating banknotes and they won’t make us better if we’re ill). The value of financial assets rests on the extent to which we can use them to obtain real assets and human services.

That brings us to another important distinction: whether or not the value of an investment relies on a market.

Market-based investments

Most of the investments we will be talking about are second hand. Even if they are ‘new’ when we buy them, the chances are we will rely on some form of market when we come to sell them. Even if we buy a new house, the land on which it is built certainly isn’t new. In fact there are very few investments that are not market based, and those that do fall into that category could be thought of as savings. For example National Savings certificates and building society bonds, both of which typically involve locking your money away for between two and five years, are not market-based or second hand investments. However they are less liquid than a normal savings account (you can’t get your hands on the cash as easily), and because of that we will discuss them in relation to investment. But bear in mind that there isn't a clear distinction between savings and investment when it comes to financial products such as NS certificates and building society bonds.

Formal and informal markets

It is also important to recognise that when we talk about markets in relation to investment, we must distinguish between formal markets or exchanges (for example a stock exchange) and an informal market such as that for property. Formal markets provide liquidity (we can convert assets into cash very easily as a rule). With an informal market we rely on finding a buyer or seller, and usually have a fairly lengthy legal process to go through. With a formal market we are almost invariably price takers. Ben Graham in his outstanding book, The Intelligent Investor, talks of ‘Mr Market’. Each day the obliging Mr Market tells you the prices of thousands of financial assets and offers to buy off you any that you have, or sell to you any that you want. He sets the prices and invites us to deal. But we don’t have to take any notice: he will be here again tomorrow, and the next day, and his prices may or may not be different.

In an informal market, we negotiate a price for whatever real or financial assets we wish to trade. In both types of market, the prices at which we can deal as buyers or sellers will depend on our views and expectations and those of other investors and traders. Formal markets make it possible for us to judge the sentiments of other market agents: we can watch prices change by the minute if we wish. With informal markets, especially involving property, the number of possible buyers or sellers may be limited and as far as real assets are concerned investment value may be only part of the equation. For that reason we may be vaguely aware of value but it only becomes an issue when we decide to buy or sell.

Now we have talked a bit about types of investment, let’s look at how we might compare them.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page