One of the crucial decisions an investor must make is how to allocate his assets. Most people choose from a narrow range of possibilities, dividing their money among such financial instruments as stocks, bonds and cash, or real estate. Now and then an individual may also decide to sink money into more esotericand less liquidinvestments such as a barrel of oil or a rare work of art.

Since these different types of investment do not move in unison, it matters a great deal how you allocate your money among them. The short- and long-term performance of one particular group of assets some researchers have tracked for many years is summarized in the table below. If you did not load up on his winters inners, take heartin the long run the value of all these assets has increasedat least in nominal terms.

The long-term performance data are expressed in compound annual growth rates. To understand the power of reinvesting, note that the 12.2% compound growth in stocks means that $1 invested in stocks in 1973 would be worth $10 today. The arithmetic of compound interest also means that what appear to be small differences in growth rates actually translate into large disparities in the terminal value of an investment. Thus, the 2.4-percentage-point difference between the 20-year growth rate of stocks and bonds means that $1 invested in bonds would be worth roughly one-third less than the same investment in stocks.

Broadly speaking, every period confronts an investor with the necessity of choosing between financial and tangible assets. An investor who correctly positions a portfolio from one period to the next stands to reap considerably greater returns than an investor who does not adjust his mix of investments.

What are the key factors that drive the performance of these two broad classes of assets? Roughly speaking, they can be summarized as follows:

Factors favoring financial assets:

1. Declining inflationary expectations
2. Peace and democracy
3. Declining tax rates
4. Deregulation and a shrinking public sector
5. Increased confidence

Factors favoring tangible assets:

1. Rising inflationary expectations
2. Political instability
3. Rising tax rates
4. Increased regulation and a growing public sector
5. Rising anxiety

Although these factors are qualitative, some general discussion of these factors in the 1993 environment is still possible.

From the above list, one can conclude that financial assets are not a good hedge in an inflationary period while tangible assets are.

Inflation is the most critical factor on this list. The direction and stability of prices affect the future value of money, and the future value of money is what investing is all about. The Consumer Price Index is included in the table of returns to help owners of these assets decide whether they are winning or losing in terms of purchasing power.

Investment Clues From the Past

[1] Corresponds to years 1973-1993

ASSET	20 YEARS RETURN[1]	RANK	10 YEARS RETURN	RANK	5 YEARS RETURN	RANK	1 YEAR RETURN	RANK
Stocks	12.2%	1	14.8%	1	15.1%	1	11.6%	2
Bonds	9.8	2	13.2	2	13.1	2	14.8	1
Stamps	9.6	3	(1.7)	11	0.5	11	8.8	4
3-month Treasury bills	8.8	4	7.3	4	6.6	4	3.3	8
Diamonds	8.5	5	5.9	5	4.3	5	1.5	11
Oil	7.5	6	(4.7)	12	1.7	12	(6.3)	12
Gold	6.9	7	(1.0)	9	(4.2)	9	9.6	3
Housing	6.7	8	4.4	7	3.7	7	1.8	10
Consumer Price Index	6.1	9	3.8	8	4.2	8	3.3	7
Chinese ceramics	5.8	10	7.6	3	9.8	3	(7.5)	13
U.S. farmland	5.4	11	(1.2)	10	2.1	10	2.3	9
Foreign exchange	3.4	12	5.6	6	1.7	6	6.2	6
Silver	2.7	13	(10.1)	13	(8.5)	13	8.4	5

Use this data to answer the following question:

A.

(10 points) Suppose you invest $1,000 in each of the assets appearing in the above table in 1973. What is the terminal value of each asset in 1993? The terminal value of your total investment? The terminal value in real terms? Why may a small difference in reported return amount to a large difference in terminal wealth?

B.

Part 1 - (10 points) Discuss each of the five factors favoring financial assets and each of the five factors favoring tangible assets. In particular, provide the transmission mechanism through which these shocks affect the stock market.

Part 2 - (10 points) Suppose we expect a drop in the inflation rate. Would you invest in bonds or stocks? Why? And if you choose bonds, would you buy long-term or short-term bonds? Explain why.

C.

(10 points) When the article was written (in 1993), one could have observed the following:

Part 1 - Inflation rates were very low and were expected to remain sooil prices were especially low. Telephone and airline companies slashed prices as a result of increased competition.

Part 2 - The Cold War era had ended. There were regions experiencing political unrest, the probability of a superpower confrontation had declined.

Part 3 - President Clinton had raised taxes and would do so again.

Part 4 - The governments role in the economy under President Clintons administration was expected to shrink.

D.

(5 points) Given these predictions, would you concentrate your investments in financial or tangible assets? If financial assets, would you invest in airline and oil stocks or auto manufacturing firms? Explain why.

E.

(5 points) Explain the relationship between the industries selected and the reason given for the decline in inflation expected in the future.