A financial portfolio is a collection of financial assets. It might include money balances, bonds, equities, mortgages, and mutual funds. The structure of a portfolio, the proportion held in each type of asset, reflects two main characteristics of the assets involved:
- The returns paid by different financial assets
- The risks arising from changes in the market prices of assets
Wealth holders and institutional portfolio managers for pension funds and insurance companies like their portfolios to pay high returns with low risk. To achieve this, they hold mixed portfolios of money and other financial assets.
Suppose you win $10 million in a lottery. Now that you have wealth, what are you going to do with it? You will no doubt spend some and give some away. That is a wealth effect, but what about the balance of your winnings? You have to make a portfolio choice. Will you hold your wealth as money in the bank? Will you put your money in the stock market? Will you put your money in the bond market?
If you consult a financial planner, he or she will probably recommend a mixed portfolio made up of money, bonds, and equities. That recommendation will be based on your intention to increase your wealth and draw income from it while protecting it from losses in financial markets.
Money holdings are an important part of the portfolio. Money is the medium of exchange. It can be used directly to make payments for goods and services or to settle debts. Other assets, for example bonds, cannot be used as a means of payment. Furthermore, money has a fixed nominal price. It is a “safe asset.” Wealth held as money does not rise or fall with the rise or fall in financial asset prices on stock and bond markets. However, money is exposed to the risk that inflation will lower its real purchasing power.
Other financial assets differ from money in three respects. First, they cannot be used as a means of payment. To use them to make a payment you would first have to sell them for money, at their current market price, and then use the money to make the payment. Second, they offer a return in the form of an interest payment, a dividend payment, or a rise in price that provides income to the portfolio holder. Third, because the prices of financial assets like bonds or stocks fluctuate daily on financial markets, these assets carry the risk that their values may decline significantly from time to time.
Portfolio management recognizes these differences between assets by trading some return for lower risk and greater convenience in the mix of assets held. Money in the portfolio offers the convenience of the means of payment, providing low risk but zero return. Other assets offer a flow of interest and dividend income, and possible capital gains if asset prices rise, but the risk of capital loss if prices fall.
This portfolio choice between money balances and other assets is the basis for our discussion of the demand for money balances in the remainder of this chapter.