Category of Assets
An asset is something that is owned with the expectation that it will provide a benefit. In some instances, the benefit is the security that the asset provides; in others, it may be as simple as pride of ownership; other assets are owned with the expectation that they will generate future cash flows. For individuals, assets can be divided into three categories: current or liquid assets; household assets; and investment assets.
Current or Liquid Assets
Current, or liquid assets are assets that can be readily converted to cash with little or no loss in value. This category of assets provides the owner with a sense of security. Checking, savings, and money market accounts (or funds) are the primary examples. The cash value of a whole life insurance policy is another. While these assets pay little to no interest, you can access the money quickly when needed. Financial gurus differ in terms of how much individuals should hold in liquid assets, but an amount equal to six months of your monthly expenses should keep you safe. Then, should an emergency occur, you would be able to handle it without having to do something drastic or financially detrimental, like getting a cash advance from your credit card company, which tends to be an expensive option, or selling shares of stock at a loss.
Household assets and possessions may be owned for various reasons. This category includes your home itself (if owned), vehicles (if owned), furniture, jewelry, and fine art, among other items. Some people get a sense of security from owning their own home; they may also feel proud to be a homeowner; and they may consider it an investment that will appreciate in value, providing them with future profits. Unless vintage or otherwise in demand, cars, trucks and boats typically depreciate in value, so they are mainly a source of pride, as is expensive furniture. Ownership of jewelry and fine art may provide both a great sense of satisfaction and the hope that they will increase in value.
Investment assets are held with the expectation that they will provide future cash flows to the investor. This category is usually comprised largely of Treasury bonds and stocks and bonds of large corporations, purchased either individually by the investor or via mutual funds or exchange-traded funds (ETFs). Treasury bonds are considered risk-free since they are backed by the “full faith and credit” of the U.S. government. Most Treasury bond issues pay interest every six months, at a specified rate, and repay the principal at maturity, as do most corporate bonds. Investors invest in corporate stock with the expectation of earning dividend and/or capital gains when they sell the stock.
When you purchase shares of a mutual fund or an ETF, you are a part-owner of the portfolio of the securities in which they invest. These may be stocks and/or bonds of domestic entities only; of both domestic and foreign entities; or of entities operating within a specific foreign country, such as Japan. As part-owner, you earn your pro rata share of the dividend and interest income that the fund receives, as well as any capital gains that the fund earns when it sells some of its securities. And, assuming the fund does well, you will also be able to sell your shares in it at a profit should you choose to do so.
But Treasury bonds and stocks and bonds of large corporations aren’t the only types of investment assets. Many savvy investors increase the expected returns on their portfolios by trading in options. Options can provide you with a substantial return on a relatively small investment. For example, at the end of April 2020, Microsoft (MSFT) was selling for $175.00. An investor who expected MSFT to increase in value to, say, $210 a share, over the next few months might purchase a call option on the stock rather than buying the stock itself. One hundred shares of the stock would cost $17,500, but a call option to buy 100 shares of the stock at $195, with a September 18, 2020 expiration, was selling for $750. The call option gives the investor the right, but not the obligation, to buy the stock for $195 anytime prior to the expiration date. If the investor does not wish to purchase the stock, he or she can sell the option prior to expiration. For example, if the stock is selling for $210 a share at some point, the investor will be able to sell the option for at least $1,500 [= ($210 – $195) x 100 shares]. That’s a return on investment of 100% (= over a holding period of only 4 ½ months. Of course, if the stock price never gets to $195 or higher prior to expiration, the investor will simply let the option expire, losing his $750 investment. It’s a risk/return tradeoff.
Some small businesses seek loans from private investors to finance their operations. Privately-owned real estate investing companies use a lot of these types of loans, otherwise known as “private placements.” When you invest in a private placement, you are loaning that company money in accordance with the specific terms of the loan. Some pay periodic interest income, just as most bonds of large corporations do, while others repay the principal, along with the accumulated interest earned, at the end of the term of the loan. These private placements are riskier than investing in the stocks and bonds of large corporations since the businesses are smaller, and because of that, they must offer investors a higher rate of return. The notes issued by real estate investing companies are usually backed by the real estate in which the company is investing, which tends to make them a bit safer since the noteholder has a claim to the underlying real estate if the company fails to make the scheduled payment(s).
Many private placements are available for purchase only by accredited investors, depending on the Securities and Exchange Commission (SEC) rule that the company used when issuing it. An individual must meet one of two criteria to qualify as an accredited investor. He/she must have:
- a net worth of over $1 million, either individually or with his or her spouse. The market value of the individual’s primary residence must be excluded in the net worth calculation according to SEC rules.
- income that exceeded $200,000 in each of the two preceding years (or joint spousal income exceeding $300,000 during that same time frame), as well as a reasonable expectation of earning that same amount in the current year.
Investors who are able to meet either one of these two criteria have a number of additional investment vehicles available to them. For example, the individual will then qualify to be an “angel investor,” someone who provides funding to startup businesses in exchange for equity (part-ownership) of the firm. As is the case with private placements, these investments tend to be riskier and, thus, offer investors a higher expected return.
But an investment in the debt or equity of other companies isn’t the only type of investment asset available to people. Like many real estate investing companies, some individuals buy a piece of real estate for the purpose of fixing it up to sell it for a profit (flipping). Others may own another type of small business—a pizza shop, a boutique, a barber shop—with the expectation that it will generate cash flow for them. Still others invest in collectibles—coins, stamps, sports memorabilia—in anticipation of being able to sell the items at a profit when they increase in value. All of these types of assets are held with the expectation that they will produce future cash flows—and thereby increase the wealth of the person who owns them.