REAL ASSETS VERSUS FINANCIAL ASSETS - WHAT'S THE DIFFERENCE?

The material wealth of a society is ultimately determined by the productive capacity of its economy, that is, the goods and services its members can create. This capacity is a function of the real assets of the economy: the land, buildings, machines, and knowledge that can be used to produce goods and services.

In contrast to such real assets are financial assets, such as stocks and bonds. Such securities are no more than sheets of paper or, more likely, computer entries and do not contribute directly to the productive capacity of the economy.

Instead, these assets are the means by which individuals in well-developed economies hold their claims on real assets. Financial assets are claims to the income generated by real assets (or claims on income from the government).

If we cannot own our own auto plant (a real asset), we can still buy shares in General Motors or Toyota (financial assets) and, thereby, share in the income derived from the production of automobiles.

While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors. Individuals can choose between consuming their wealth today or investing for the future. If they choose to invest, they may place their wealth in financial assets by purchasing various securities.

When investors buy these securities from companies, the firms use the money so raised to pay for real assets, such as plant, equipment, technology, or inventory. So investors’ returns on securities ultimately come from the income produced by the real assets that were financed by the issuance of those securities.

Household wealth includes financial assets such as bank accounts, corporate stock, or bonds. However, these securities, which are financial assets of households, are liabilities of the issuers of the securities. For example, a bond that you treat as an asset because it gives you a claim on interest income and repayment of principal from General Motors is a liability of General Motors, which is obligated to make these payments to you.

Your asset is GM’s liability. Therefore, when we aggregate over all balance sheets, these claims cancel out, leaving only real assets as the net wealth of the economy. National wealth consists of structures, equipment, inventories of goods, and land.

We will focus almost exclusively on financial assets. But you shouldn’t lose sight of the fact that the successes or failures of the financial assets we choose to purchase ultimately depend on the performance of the underlying real assets.