Since last week went so well, here’s another post from Eddie. He blogs at Summaticus, which is worth a couple minutes of your time.
Every human being lives in a world governed by the laws, principles, and concepts of economics. Our lives are subject to the principle of scarcity, in that the earth only possesses limited resources to satisfy our infinite needs and desires. At a microeconomic level, a person has a limited amount of capital to satisfy their needs, wants, and aspirations. Therefore, we must hone our decision-making skills when deciding how to allocate our most scarce and precious resources: time and money.
One concept that could be useful in making economic decisions is to use a simple model to classify assets into certain types. Dividing the plethora of investment and consumption decisions into a simple framework will enable us to make better and more rapid ones.
One effective paradigm is to classify assets according to the following criteria:
Appreciating/Depreciating – an appreciating asset is one that increases in real value over time. A depreciating asset decreases in value over time
Productive/Non-Productive – a productive asset is one that bestows dividends and income to the owner, whether they be direct or indirect
Benefits and Costs of Ownership
It is necessary to examine compensation and the benefits and costs of ownership before proceeding further. Dividends and income are cash or compensation paid to the owners of the asset because of their ownership of it. For example, shares of mature companies, such as large banks, pay dividends every quarter to their shareholders. Likewise, acquiring a franchise permits the owners to pay themselves income providing they have the cash flow to do it. A capital gain (loss) occurs when the owner of an asset sells it for more (less) than he or she paid for it.
|Productive||Dividend/income, capital gains||Dividend/income, capital loss|
|Non-productive||Capital gains, maintenance and upkeep costs||Maintenance and upkeep costs|
While there are obviously upkeep and maintenance costs to all assets, I excluded it from productive assets under the logic that income derived thereof exceeds the costs to maintain them.
Most assets, but not all, can be described by the criteria of appreciating/depreciating and productive/non-productive and are expressed below, with examples:
|Productive||Real estate rentals, land, well-run businesses, securities (increasing in value)||Real estate rentals, poorly-run businesses, securities (decreasing in value), GICs, equipment, machines, tools, factories|
|Non-Productive||Art, collector cars, coins, stamps, vacation properties||Watercraft for personal use, most cars, personal electronics|
The examples provided in the table are generalized but nonetheless illustrate the point. A well-run and profitable business will not only provide ongoing income, but will likely have a higher terminal value than the purchase price. This makes it an appreciating and productive asset. A non-productive, appreciating asset like a coin collection or a classic car will not pay dividends through its life, but will likely be sold for more than its purchase price (though obviously not always).
The column illustrating depreciating assets is much more interesting. Non-productive, depreciating assets will lose their value over time and cost more to maintain or possess than any income which can be derived from their use. These include personal watercraft, most cars, and personal electronic, such as an MP3 player. This constitutes the ‘overhead’ of living life and should be minimized or avoided.
The most varied class is characterized by being depreciating and productive. Most businesses cannot operate without these types of assets, such as work trucks, tools, equipment, and machinery. While they do not produce direct income, the business could not operate without them. These provide a net benefit to the business. An example of a poor type of depreciating and productive asset is that of a Guaranteed Income Certificate (GIC). GICs provide income through interest but are nonetheless depreciating assets as inflation will often outpace the coupon rate on the GIC and real value (not nominal value) will decline. Avoid these types of assets, and you’ll do fine.