• PHYSAL AND FIICNANCIAL ASSETS
• Liquidity
• Risks Involved
• The Importance of Diversification

PHYSICAL AND FINANCIAL ASSETS

Introduction: There are many kinds of assets in which people can invest. Physical assets (those that are tangible) constitute one category. This includes items such as houses, coins, and works of art. Some physical assets, such as a house, can both meet current living needs and serve as an investment, since house prices have historically risen in value over time. Also, physical assets often provide their owners with an emotional return that is separate from any financial reward. Examples include the pride of home ownership and the sense of beauty that a work of art can bring.

Financial assets, a second category, include stocks and bonds issued by companies to raise capital for the operation and expansion of their businesses. After the initial sale is completed, these securities are often available for resale through markets such as the New York Stock Exchange (NYSE). In addition to stocks and bonds, various other financial assets are readily available to the public. Among them are debt securities issued by the federal, state, and local governments; money market funds; traditional bank accounts; certificates of deposit; mutual funds; options; and futures.

While financial assets represent much more than just pieces of paper, they are an indirect and less tangible form of wealth. Another way in which financial assets differ from physical assets is that they often generate cash income for the owners in the form of dividend or interest payments. Physical assets, in contrast, may require cash outlays during the period in which they are owned. For example, maintenance, repairs, and insurance on a building must be paid by the owner. However, a primary investment aim of owning either physical or financial assets is to be able to sell them at some future time for more than it cost to acquire them.

Liquidity: Some spectacular gains in value have come from physical assets. During portions of the past two decades, real estate prices boomed and rare-art auctions generated record prices. As prices paid for these physical assets began to soften toward the end of the 1980s, however, a significant drawback became more apparent: a lack of liquidity. Whereas most financial assets can be bought or sold at a moment's notice, it's harder to sell a physical asset such as a house. This is largely because huge quantities of financial assets are bought and sold every day and the marketplace for them is a national one. Furthermore, for any given company, one share of common stock is identical to every other. Often, in a single day, such shares have hundreds of buyers and sellers who establish, through their transactions, the current value of the asset. In contrast, a house or a painting is generally a unique asset; nothing else exactly like it is available for sale. This quality of uniqueness adds to the complexity of finding a buyer and seller who can agree on a sale price for the asset.

How readily an asset can be turned into cash (the ease with which buyers and sellers can be brought together and can agree on a price) is called liquidity. Assets that are less liquid tend to have a wider spread between the "bid" (the price offered by a would-be buyer) and the "ask" (the seller's asking price). Among financial assets, some are more liquid than others, an important consideration in assessing risk. Some limited partnerships, for example, have little or no liquidity and should be bought only with the expectation of holding them until maturity. The illiquidity of such partnership interests largely reflects the absence of a public market for the trading of partnership shares. In addition, the structure and assets (e.g. specific pieces of real estate) of such partnerships may be tailored to the financial needs of a relatively small group of investors, which may narrow the resale potential of a partnership interest. In contrast, money market funds, a type of mutual fund that invests in short-term debt instruments, are so liquid they are considered to be cash equivalents. Most brokerage firms will automatically place your uninvested funds in a money market fund, where you will earn a slightly better rate of return than you would with a savings account at a bank, and your money will normally be immediately available.

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Other Risks: All prospective investments should be evaluated in terms of the trade-offs between risk and reward. The expected return on an investment may be based largely on its historical performance, but, because there is no guarantee that the future will repeat the past, you should assess the possibility that you won't reap your target profit.

One measure of risk and return is the range of possible outcomes. With a U.S. Treasury bond, you are assured of getting a series of modest interest payments and your principal the amount of your initial investment) will be preserved if you hold the bond to maturity. With the riskiest of investments, such as the speculative purchase of a stock option, you may quadruple your money or you may lose it all. In addition to the matter of liquidity, there are at least three other kinds of risk to consider: credit risk, interest rate risk, and price volatility.

Credit risk and interest rate risk are the primary concerns with bonds and other fixed-income securities. The role that each of these two risks plays varies according to the type of investment. U.S. government securities, for example, have very little credit risk because it is highly unlikely that the federal government will default on its commitment to pay interest and principal on debt. Because of this low credit risk, the long-term rate of return on such government securities tends to be lower than that available with other investments. Government securities, however, do share a risk with other fixed-income instruments, the interest rate risk. If an investor elects to sell such a security prior to maturity, the market price will depend largely on the prevailing interest rate environment.

If rates have risen since the security was purchased, the investor will likely have to sell the security for less than the purchase price.

Another measure of risk is price volatility. Although prices for bonds and other fixed-income investments fluctuate as interest rates change, these fluctuations are usually small. Even though normally less volatile than the options market, stock market returns do vary widely. As a result, investors in the stock market should have a longer time frame and a greater risk tolerance than is advised for some other, less volatile forms of investment. Although historical returns on long-term stock investments have been relatively high, stock prices tend to move more rapidly and to greater extremes than prices of most other kinds of financial assets.

Potential stock market investors should reflect on how much their financial and emotional comfort could be tested in periods of declining prices. During the 1980s, in particular, the return from bonds was unusually high, largely due to declines in interest rates.

In an extreme example, the stock market declined more than 20% in value on a single day in October 1987, wiping out the gains of more than two years. Investors shaken by this experience may have sold their shares and put their money into a safe haven, such as a money market fund. In doing so, however, they would have missed out on the above average gains from stocks that followed.

If $10,000 had been left in the stock market following that dramatic 1987 decline, it would have grown to about $23,000 in value by the end of 1993, assuming the reinvestment of dividends. In comparison, the same $10,000 in a money market fund would have grown to only roughly $14,000. Of course, there have been other periods, of even five years and longer, when stocks have declined in value and the returns from other safer, or less volatile, kinds of investments would have been significantly better. But for investors who have a long-term time horizon and who are willing to ride out the volatility, history indicates that to earn a high return, a meaningful portion of their invested capital should be in stocks.

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The Importance of Diversification:Diversification of investment holdings is the most important shield against risk. Because some investments rise in value while others fall, diversification smooths out much of the volatility of the overall return from a portfolio. Diversification sacrifices some of the upside potential, but this should be more than offset by the benefits of a lower level of risk.

The point is: Don't put all of your eggs in one basket. Although the attractiveness of stocks over the long term is stressed in this publication, all your investment capital should not go into this class of assets. In addition, you should diversify your holdings even within each class of assets. For instance, a list of 20 stocks, spread across different industries, provides adequate diversification for an equity portfolio. To diversify a fixed-income portfolio, securities should be held with different risk levels and different dates of maturity.

Anyone with less than $20,000 to invest in stocks or bonds should seriously consider mutual funds because of the diversification they provide. Also, for both small and large investors, placing some money in funds can offer relief from the task of selecting individual securities. (For a fuller discussion, see Mutual Funds)

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