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Investment and The Economy

Harvard (Charles River) IMG 7721
(Harvard University - Harvard Taiwan Student Association)


Learning by Doing


- The Stock Market and The Economy

Investment is one of the most important variables in economics. On its back, humans have ridden from caves to skyscrapers. Its surges and collapses are still a primary cause of recessions. Indeed, investment has dropped sharply during almost every postwar U.S. recession. One cannot begin to project where the economy is going in the near term or the long term without having a firm grasp of the future path of investment. Because it is so important, economists have studied investment intensely and understand it relatively well.

The stock market is an excellent economic indicator for the U.S. economy. It reflects how well all listed companies are doing. If investors are confident, they will buy stocks, stock mutual funds, or stock options. Some experts believe markets predict what the savviest investors think the economy will be doing in about six months.

However, the stock market Is not the economy. Despite its critical role in the economy, the stock market is not the same as the economy. The stock market is driven by the emotions of investors. They can exhibit irrational exuberance. It occurs during an asset bubble and the peak of the business cycle. They become overly optimistic even though there is no hard data to support it. The peak occurs right before a crash.


- An Investment

An investment is an asset or item acquired with the goal of generating income or appreciation. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit.  An investment always concerns the outlay of some asset today (time, money, effort, etc.) in hopes of a greater payoff in the future than what was originally put in.


(Huangshan, Anhui Province, China - Hsi-Pin Ma)

- Asset Classes

The growing number and complexity of asset classes, disruptive worldwide economic and regulatory environments, emerging technologies, and shifts in investor behaviors and preferences make it challenging to keep knowledge and skills current. Investment strategies and portfolio management addresses all of these concerns.  

An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Investment assets include both tangible and intangible instruments which investors buy and sell for the purposes of generating additional income on either a short- or a long-term basis.

Historically, the three main asset classes have been equities (stocks), fixed income (bonds) and cash equivalent or money market instruments. Currently, most investment professionals include real estate, commodities, futures, other financial derivatives and even cryptocurrencies to the asset class mix. 

Each asset class is expected to reflect different risk and return investment characteristics and perform differently in any given market environment. Investors interested in maximizing return often do so by reducing portfolio risk through asset class diversification.


- The Business Cycle Approach to Asset Allocation

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance, and investment horizon. The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.

The business cycle reflects the aggregate fluctuations of economic activity, which can be a critical determinant of asset performance over the intermediate term. Changes in key economic indicators have historically provided a fairly reliable guide to recognizing the business cycle’s four distinct phases - early, mid, late, and recession. 

An approach that seeks to identify the shifting economic phases, providing a framework for making asset allocation decisions according to the probability that assets may outperform or underperform. For example, the early cycle phase is typically characterized by a sharp economic recovery and the outperformance of equities and other economically sensitive assets. This approach may be incorporated into an asset allocation framework to take advantage of cyclical performance that may deviate from longer-term asset returns.


[More to come ...]

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