Tuesday, February 26, 2013

Investment Part 1: The Basics

One of those quirks of being an economist is few people really understand your job. A large portion of introductory conversations eventually turn towards the next hot stock tip or investment idea. The fact is that while most economists probably have an opinion of what direction the economy is moving in, they probably don't have much interest in individual stocks. While economists are well equipped with the tools for financial analysis many if not most (at least within academia) simply do not pursue that vocation.

The overall mechanisms of investment and trade however are important concepts in economics. This posting will attempt to provide a basic outline of investment principles from which to expand in next weeks submission, which will discuss equity pricing.

The fundamental idea behind investment is essentially the same regardless of mechanism.  You employ resources now in order to realize future gains.  The most commonly discussed resource is currency, but other resources include time, materials, land, and anything else that can be utilized or expended for gain. For example, spending the time and money in order to gain a high school diploma is an investment. An individual loses the time they could have been using in more financially productive ways in order to gain higher average wages later in life.

However, most of the time when people discuss investment they mean using excess money (or credit) to earn returns at a future point. Currency can be used in several ways in order to gain a return. Stocks, bonds, real estate, currency trading, commodity trading, annuities and entrepreneurship are only the most common. I'll touch briefly on each of these before exploring stocks and bonds in greater depth next week.

Annuities are very simply directly buying a revenue stream. A person who has more money than they require at the moment may purchase an annuity which will pay out a larger amount of money over time. The core concept behind this investment is the time value of money. Essentially money now is worth more than money in the future (due to expected inflation, risk and liquidity factors). Therefore some firms are willing to take $1000 now and return a larger amount, for example $1200, over the next ten years. The amount returned varies proportionally with the agreed upon time period. In other words the longer the period you are paid back over the more you will receive overall.  Annuities are generally a safe but not very profitable investments. The investor is generally left better off than if they did nothing with their excess funds, but not by much after inflation is considered.

Many investments directly mirror the annuities "pay now get more back later" style. Certificates of deposit for example are essentially a promise to allow a bank to hold your funds for a given time. In return they provide interest to compensate you for the use of your funds. The only real difference between purchasing an annuity and "rolling" certificates of deposit is that the certificate gets the benefit of compound interest.

Of the methods of investment listed entrepreneurship is the most unique.  Utilizing resources in order to establish a business which will provide a future revenue stream is a concept most people can easily grasp.  If an individual expends a thousand dollars in order to create a business that returns a dollar a day he has from a financial perspective bought a revenue stream very similar to an annuity. However, owners have a great deal more influence on how much a business returns than annuity holders have over their annuities. Business ownership rewards many factors which other investments neglect, such as innovation, the owner's labor, and sound planning. No matter how intelligent or hard working you are it's unlikely you'll find an annuity that provides a much better return than the market average.  Businesses are also the most independent of market forces.  While a portfolio consisting of Apple stock will vary exactly with the price said stock, an arts and crafts store will not immediately declare bankruptcy if the price of paper increases significantly.  That's not to say that the price of real estate won't have a large impact on a real estate office, but more factors go into a business than most investments.

Real estate, currency trading and commodity trading all work given a relatively simple market system. As supply rises or demand falls prices fall. When demand outstrips supply prices rise. A variety of factors complicate the market but at it's core supply and demand rule. Thus when the world economy is booming more power is demanded to keep all the factories, cars and new electronics running so oil prices rise. When the economy pulls back some of those factories shut down, more people are out of work (and thus commute less), and oil prices fall.  Similarly when the United States prints more dollars supply rises and the value of the dollar falls.

Next week I'll continue on this topic with a focus on stocks, bonds and in particular how the prices for those two investment vehicles are created.

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