# Portfolio Choice

Portfolio choice involves decisions about the way we want to hold our assets (or to structure our liabilities).1 It is a fancy term for something we do all the time. For example, a yard sale is an example of portfolio adjustment. People holding a yard sale are attempting to convert assets in the form clothing and household items into cash. They are not changing the amount of assets they have, but rather the form in which they hold them.

From a macroeconomic perspective, most important cases of portfolio adjustment involve financial assets. When we look at financial assets, there are three characteristics that most people want to have in their assets. First, they like assets with low risk. Second, they want assets that are liquid, assets that can easily be converted to money and spent. Third, they like assets that give them a high rate of return. Because no asset combines all three characteristics, people face tradeoffs. If they want a higher return, they usually have to accept more risk or less liquidity. For example, over the past half century the average return on holding common stocks has been higher than the return on holding passbook savings in a bank. However, the high average return on common stocks is the result of some stocks performing very well while others perform poorly. Investment in stocks can be quite risky.

Many issues in portfolio choice can be illustrated with a balance sheet. A balance sheet is based on the definition of net worth or wealth:

(1) Net Worth = Assets - Liabilities

An asset is what one owns and a liability is what one owes. Using very elementary algebra, one can rewrite this equation as:

(2) Assets = Net Worth + Liabilities

Since this equation is based on a definition, the right-hand and left-hand sides must equal each other or balance, and hence the name balance sheet.

Balance sheets provide a precise way to analyze banking transactions. To give you some taste of what is to come, consider the table below which shows balance sheets of a hypothetical commercial bank and one of its customers. The deposits of customers are liabilities to the bank because they are amounts that the bank owes to them. On the other hand, these same deposits are assets for the customers. The loans the bank makes to consumers and businesses are assets to the bank but liabilities to the consumers and businesses.

 Hypothetical Balance Sheets Commercial Bank . Germaine Assets . Liabilities and Net Worth Assets . Liabilities and Net Worth Vault Cash \$1,000,000 loans \$9,000,000 Checking Deposits \$4,9000,000 Savings Deposits \$4,900,000 Net Worth \$200,000 Deposits at Bank \$400 cash \$200 car \$3000 personal items \$2000 Loan from Bank \$2000 Net Worth \$3600

Suppose that Germaine, the bank customer, decides to deposit into a savings account some of the cash she has in her piggy bank. The effect on the bank will be to increase its vault cash on its asset side and also to increase its savings deposits on its liability side. For Germaine, the transaction will not affect the liability side of her balance sheet at all. She will reduce her cash holdings and increase the amount she has in her savings account. As a result of this portfolio decision that Germaine makes, she will earn a higher return on her assets than she did before, but she will have slightly less liquidity. If Germaine deposits \$100, we could show the effect of her actions by putting in only the changes, which is done below. Notice how balance is preserved on both sheets.

 Hypothetical Balance Sheets--Changes Commercial Bank . Germaine Assets . Liabilities and Net Worth Assets . Liabilities and Net Worth Vault Cash +\$100 loans -- Checking Deposits -- Savings Deposits +\$100 Net Worth -- Deposits at Bank +\$100 cash -\$100 car -- personal items -- Loan from Bank -- Net Worth --

Next we consider whether financial speculation may be a source of economic disturbance.

1 Do not confuse portfolio choice with decisions to spend or save, very different decisions that are also important in economics and that also usually involve financial markets.