Investing in the 21^st Century

What is wealth? What does it mean to be wealthy?  How does one accumulate and store wealth?  It is never too early to begin thinking about these questions.  Once you begin to think about these questions, however, you will realize there are no simple answers.  Not everyone could agree on how to define wealth, and there certainly would be disagreement on how one accumulates wealth. What you can be certain of is that over your lifetime you will be inundated with get rich quick schemes, opportunities to maximize your wealth and minimize your risk, and you will need to be able to get past the hype and make some good choices. 

In the diagram below you see wealth can be defined rather broadly to include economic and non economic wealth, although the distinction between the two is often times not clear.  The friends we choose can have a definite impact on our economic wealth, while economic wealth can influence one's list of friends.   You might have a good friend who knows about a great opportunity to buy a stock, or you may have a friend in the real estate business who turns you on to a great deal.   Similarly, you may find your friends are influenced by your wealth since where you live, shop, and recreate all are probably related to your wealth.  If you have any doubts, check out the clientele at the Dunes Club and Scarborough Beach in Narragansett, or the Exeter and Point Judith Country Clubs. 

You can also expect there would be a link between health and economic wealth.  If you happen to have a series of serious medical problems, it is very possible that you will have difficulties holding down a full-time job with considerable opportunities for advancement.  Similarly, if you have considerable economic wealth you will have few difficulties buying good health care services. 

In the discussion of wealth here, we are going to focus our energies on economic wealth.  Under the heading of economic wealth, we have the division between real and financial assets.  Real assets are generally "things", while financial assets are pieces of paper with promises to pay money at some point in time.  The important choices you will need to make center on your purchases and sales of assets.  What do you buy and when?   When should you sell and what should you sell?  What we are talking about here is developing an investment strategy.  You may buy a home, stock in Microsoft, a Rembrandt painting, gold, or you may just deposit it in a checking account.  What you care about is buying low and selling high.  You make money if the price of any asset you purchase increases in price.

Once we focus our attention on price, however, we can return to our model of prices - the demand - supply model.  This is the common denominator in the analysis of assets. You can think of the return you get on the asset you buy as being dependent upon the changes in the price of the asset, movements you can explain / predict with the basic supply-demand model pictured below.   If you buy low and sell high you will make money - if you buy high and sell low you will lose money.  The secret is to be able to predict movements in the supply and demand curves - precisely what the hedge funds did a poor job of in 1998 which led to multi-billion dollar losses. If you are interested in a good site with a considerable amount of information which you could use to explain / predict movements in the curves you should check out Dr. Yardeni's web site or Yahoo's Finance and Investment site. You might also want to check out the e-trade site where you will find a stock market game.

Asset Market

There is one feature of asset markets that is worthy of note before we move on.  Asset markets have always been prone to wide price swings. The earliest mentioned speculative bubble, in the property market in Athens, burst in 333BC, while one of the more widely noted bubbles was the run-up of tulip prices in the 1630s dubbed - Tulipomania. And let's not forget the real estate market bust in Japan in the 1990s, those stock market crashes in the US in 1929, 1987, and 1998, or the exchange rate and stock market collapse's in Asia and Latin America in 1997 and 1998.

The volatility of asset markets can be attributed to the nature of demand.  When you buy food you buy it because you are hungry, and when you buy clothes you do so because you need clothes.  As a result it is unlikely demand will change sharply from one day to the next or from one month to the next.  Things are different, however, when we look at asset markets where people buy the assets primarily for the appreciation in price.  You will buy gold because you think the price of gold will rise, not because you want to have gold plating done in your bathroom.  You may buy a piece of art because you like it, but serious investors buy art because they think it will appreciate in value.  It is a good place to store money. 

The problem is that this type of demand depends heavily on expectations - at least in the short-run.  What we find in the short-run is prices depend more on psychological factors than economic factors.  The result is investors have what is referred to as a 'herd' mentality.  You could envision them sitting with their hands on the buy/sell switch waiting to hear the latest news.  This was certainly true in the real estate bust in the late 1980s, the stock market crash in 1987, and the currency crises in 1997-98 that wreaked havoc on East Asian and Latin America currencies and stock markets.  For example, by the end of July in 1998, stock market indexes in Korea, Brazil, and Argentina were down nearly 50 percent from the opening values on January 1st.  Given these features of generic asset markets, let's look at the individual investments.

Where should we invest?  Where should we put our money?   This is a very important questions.  If you invest $1,000 a year for the next forty-five years, you will have accumulated approximately $210,000 if your average return (interest rate) is 5 percent.  If you happened to have been able to get 10 percent a year, at the end of forty-five years you would have accumulated nearly $720,000.  The rate of return on your investment obviously matters greatly, which is why in 1999 we saw the rate of return at the center of the debate over the privatization of social security.  Those pushing privatization wanted the social security deductions from paychecks invested in the stock market where it will earn a high rate of return so retirees will have more money when they retire.  At least this is what they promise.

But where does one get the best return on the investment?   Where can you put your money today so you will see your money grow most rapidly?  As you would expect, there is no simple answer to this question.  Actually there are many answers since many individuals earn a living providing this type of advice.  What you can be sure of is there are no SURE THINGS, and there are MANY possible assets you could invest in to see your wealth grow.  You could invest in stocks, pork bellies, impressionist paintings, early American furniture, commercial real estate, foreign currency, foreign stock markets, or US Treasury bonds. In this unit we will look at a small subset of the possibilities, the assets listed below.  If you are interested in looking at the rates of return on a variety of "collectibles, you should review Burtons' and Jacobsen's article, "Measuring Returns on Investments in Collectibles" in the  Journal of Economic Perspectives (Fall 1999). 

• Human Capital (people)
• Real Estate and Gold
• Stocks
• Bonds

Before we begin to look at the details associated with any of these assets, we will take a quick look at an individual's personal finances to see the relationship between income, wealth, assets, and liabilities.  The two important financial statements we will need to know something about to understand the relationships are the income and balance sheets. 

To understand the difference consider the task of establishing a visual record of a person. There are two ways to capture this "Kodak moment."   The first is a video that would allow you to capture movement over time, while the second would be a snapshot capturing someone at a certain point in time.   The same is true when we look at finances.  One approach would be the equivalent of a video where we would measure the flow of money over a certain period of time.  This is easy enough to measure - we take the money earned in a year and subtract from it all expenses. If we are spending more than we are earning, the difference is made up with our borrowing - what you do each month when you do not pay what you charged that month. A financial statement that contained theses data would be called an income statement. A sample income statement appears below.

Chris's Income Statement

In 1997 Chris earned $8,487, not a bad year for a student.   $450 of this income was dividend income from the ownership of stock and $37 came from interest on a bank account.  Under expenses, tuition is $0 since Chris's parents pay the tuition, room & board, but Chris did pay $1,000 in 1997 on recreational expenses.  At the end of the year, after paying taxes, Chris ends up with $1,334.  To make sure that you have mastered the concept, you should try to fill in the blanks for 1998.

The second approach would be the equivalent of a snap shot where you measure how much someone is worth at a certain point in time.  An example would be the balance on a credit card at the statement date. This would be an input into one side of the financial statement called a balance sheet designed to answer the "what am I worth" question. The answer can be found in the Net Worth figure - the difference between the value of what you own (UOMe) and what you owe to others (IOU). Your liabilities (IOUs) would include the value of what you owe, including home mortgages, car or educational loans, and credit card balances.  A sample balance sheet appears below.

Chris's Balance Sheet

The secret to increasing your wealth is to invest in assets that increase in value and translate into a higher net worth.  You want to buy low and sell high.  Now it's time to look a little more closely at the specifics of stocks, bonds, real estate and gold, and human capital.  Once you are done here you will ready to take on the financial pages which offer some of the best examples of supply and demand in action.  You should be able to translate many of the headlines into shifts in the underlying supply and demand curves in the individual markets.    

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