4.1 - Financial Assets
Money, Deposits, and Liquidity
The most liquid forms of money are cash and demand deposits, which is just the fancy term for the money sitting in your checking account. They’re called “demand deposits” because you can walk into the bank whenever you want and demand your money back. People hold onto money for one simple reason: so they can buy stuff.
Liquidity describes how quickly you can turn a financial asset into cash. Money itself is the most liquid thing there is, since it already is cash.
Time deposits, like CDs (certificates of deposit), work differently. The bank makes you agree not to touch your money for a set period, usually at least six months, which makes them much less liquid than a checking account.
Rate of Return and Opportunity Cost
The rate of return is just the net gain or loss on an asset. Here’s the catch with cash: its rate of return is zero. You just don’t earn interest on it. Savings accounts are similarly liquid but pay next to nothing in interest. Time deposits pay a bit more, but you’re trading away liquidity to get it.
This is where opportunity cost comes in. The opportunity cost of holding money is whatever interest you gave up by not putting that money into something like bonds instead. It’s the classic economic lesson that everything involves a trade-off.
Risk and the Liquidity/Return Trade-Off
Liquidity and rate of return tend to move in opposite directions. Think about a house: it’s about as illiquid as it gets, but it usually has a great rate of return.
Risk is the chance that an investment turns out worse than expected, maybe even resulting in a loss. And risk and return usually move in the same direction: the riskier something is, the higher its potential payoff.
Stocks, Bonds, and Interest Rates
Stocks are shares of ownership in a company. They’re generally riskier than bonds, so they pay a higher return.
Bonds are basically IOUs. You lend money to a company or government, and they pay you back with interest. Bonds are safer than stocks, so they pay less.
You’ll also see stocks called equity (you own a piece of the company) and bonds called interest-bearing assets (they pay you interest). Both are things people hold in place of cash and checking deposits: you give up some liquidity, and in exchange you can earn a return that cash never pays.
Here’s an important relationship: bond prices and interest rates move in opposite directions. Whatever happens to interest rates, the opposite happens to bond prices. If current interest rates drop, older bonds that were issued at higher rates suddenly look really attractive, so people bid their price up.
Here’s why, with numbers. Say you bought a bond last year for $1,000 that pays 5%, or $50 a year. Now interest rates rise, and new $1,000 bonds pay 10%, or $100 a year. Nobody will pay you $1,000 for a bond that pays $50 when they could buy a new one that pays $100, so the only way to sell yours is to lower its price. The price keeps falling until your bond’s $50 a year is as good a deal as the new bonds. So when interest rates rise, the price of previously issued bonds falls, and when rates fall, their price rises.
Bottom line: liquid assets like cash pay basically nothing, while riskier or less liquid assets like stocks and real estate offer higher potential returns. And remember: bond prices and interest rates always move opposite each other.