The first step in understanding money is understanding what assets are. Assets are the things you own that are positive to your portfolio.
So what does this mean?
Basically, an asset is something that is valuable in itself.
Cash has value. You can trade it directly for other goods. Cash is also special in that it is a liquid asset. You can access the value immediately.
Clothes, furniture, and home decor also have value. However, these are non-liquid assets, meaning you can only access the value of the asset by selling it and exchanging it for cash.
An important point to note: the value of material non-liquid assets are usually not equivalent to the price you paid for them. The only way you can access the value of material non-liquid assets is by selling them in some way, usually at a steep discount to the original purchase price. For example, say you are willing to pay $20 for a new top in a store. Would you still be willing to spend $20 for the same top worn by someone else for a day? How about the same top worn by someone for 10 years? How about the same top, not worn by anyone, but 10 years old? The value of material non-liquid assets is affected by time and use.
A car is one of the most common examples of a non-liquid asset. As soon as you buy a new car and drive it off the lot, it decreases in value. It is considered “used.” The value continues to decrease as the use, primarily mileage, accumulates.
So, if everything loses value over time and with use, why have assets? Well, there is another kind of asset…income producing. Assets that produce income have inherent value, and that value increases with time.
For example, consider a Certificate of Deposit (CD). A CD is a way to save a set amount of money, for a set amount of time, and have it earn an annual percentage yield (APY). For example, say you agree to save $1,000 for a year in a CD at a 1.0% APY, compounded daily. You would not be able to access the money for a year (making it a non-liquid asset), but you would have $1,010.05 in liquid cash at the end of the year.
Now consider a high yield savings account (HYSA). For example, say you agree to save $1,000 for a year in a HYSA at a 1.0% APY, compounded daily. Like the CD, you would have $1,010.05 at the end of the year. Unlike the CD, you could access these funds whenever you want. A HYSA is a way to save liquid, income producing cash.
Stock and bonds are the most common income producing assets, but they are not entirely liquid. You still need to sell or exchange them to access their value. These trades are usually completed quickly, you can predict the value easily, and most of the time you can acquire the entire value of the asset when you sell. Therefore, you cannot entirely call them non-liquid assets either.
THE ASSET DIAGRAM
I know what you are thinking: “Hold on, I thought the three types of assets (liquid, non-liquid, and income producing) were independent of each other?”
Assets can be of the three types, but they can also overlap, like on a ven diagram.
If we use an example of a person’s total assets, they may look something like the diagram below.
Note, you can only count a home as an asset if it is entirely paid off. If it is not paid off, you can only count the equity in the home (the amount of money you have put into the home versus the amount you owe) as an asset. The same can be said for a car. You can only count a car as an asset if it is entirely paid off. Otherwise, you can only count the value of the car minus what you still owe.
WHAT ASSETS SHOULD I PREFER?
You have been introduced to the three kinds of assets and how they interact with each other. So which kind of asset should you prefer?
Let’s put some numbers to this question. Say you have $10,000 in liquid cash, a collectible coin assessed to be worth $10,000, and $10,000 in an account earning 1.0% APY compounded monthly. Assuming the collectible coin’s value remains constant, how much would each asset be worth in liquid cash at the end of one year?
So why is the collectible coin end-of-year total less when it is “worth” $10,000? Because in order to convert the coin into liquid cash, you need to sacrifice a certain percentage. For example, you need to consider documentation for the assessed value of the coin, fees to sell the item, and possible travel or shipping costs to transport the item to the buyer. Not to mention all the time and effort put into selling the non-liquid asset.
The cash is worth the same as it was at the beginning of the year. This would be fine if money retained it’s value, but inflation reduces the purchasing power of money over time. Assuming an inflation rate of 3.0% per year, each of the three totals above would actually have the following purchasing power at the end of the year:
After accounting for inflation, the account with a 1.0% APY has the highest purchasing power. However, this value is still below the original value of $10,000. You would need an asset that produces income at a rate at least equal to the inflation rate to retain the purchasing power of your money perpetually.
So, what types of assets should you prefer? The answer is liquid, passive income generating assets. Preferably the asset should be producing passive income to at least meet, if not beat, the rate of inflation. You want to be able to access the money whenever you want, but you also want your assets to be protected from inflation over time.
This is why so many people invest in the stock market. The stock market is a fairly liquid asset, and the returns have been known to beat inflation rates. These factors are important, especially when you are saving for long terms goals like retirement.
Now that you know what assets are, figure out what kind of assets you have and categorize them in your own ven diagram. How does your diagram look? Are you happy with how it looks? Let me know in the comments!
Next time, we will discuss liabilities.