What is the Difference Between Real Assets vs. Financial Assets?
Financial assets represent claims against an underlying company, so the value of financial assets depends on the underlying asset, e.g. a corporation that raised capital through selling shares or issuing debt.
The relationship between real and financial assets is that financial assets represent claims to the income produced by real assets.
Land and machinery are “real” assets, whereas stocks and bonds are “financial” assets.
- Issuer: Financial assets appear on the liabilities and equity side of the balance sheet.
- Owner: Financial assets appear on the assets side of the balance sheet.
One drawback to real assets compared to financial assets is that real assets are less liquid because the marketplace has less volume and trading frequency.
Thus, the price reflected on real assets tends to be a rough estimate with a much larger spread than for financial assets, i.e. there is less market efficiency.
Conversely, financial assets trade hands each day, and the price reflected can be updated in “real-time.”
The valuation of real and financial assets shares many similarities, such as being largely related to their ability to produce cash flows, but real assets are recorded at their historical value and reduced by depreciation, if applicable.
On the other hand, the market value of financial assets is often readily available to observe.
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What is Inflation Hedging?
One distinct benefit of real assets is that such investments can function as a hedge against inflation.
Historically, the asset class has fared better than other riskier asset classes during periods of inflation as well as during economic downturns.
Even if the fair market value (FMV) of an asset such as a house or building were to drop substantially, the widespread view is that the asset can most likely recover once the economy normalizes (and the cyclicality passes).
The same cannot be said about equities and debt securities – particularly riskier instruments such as derivatives and options – which can effectively be wiped out and lose the entirety of their value.
For instance, stocks that represent ownership stakes in a company could become worthless, or a corporate can default on its bonds.
Of course, the value of real assets can fluctuate substantially during recessions, but there is typically a certain dollar amount of value tied to the asset at all times.
For example, the asset class suffered from steep declines in value during the housing crisis in 2008, yet the period was largely temporary as pricing eventually recovered – but a significant number of financial assets saw far more volatility, and many were unable to withstand the market crash.
On the other hand, during periods of positive economic growth, the value of these assets also rises – meaning that real assets mitigate losses during recessionary periods yet still benefit from the upside during expansionary cycles.
Portfolio Diversification Example
The relative detachment from the equities market and mitigation of inflationary risk serve as another benefit to investing in real assets.
Thus, real assets are oftentimes utilized for purposes of diversification, especially considering their demand tends to be inelastic.
More specifically, the asset class portrays inelastic demand because houses are necessary as consumers will always need a home for shelter, to sleep in, etc.
As another example, farmland is used for agriculture and the production of crops, which is an essential part of human life.
Given the historically low correlation to the equities and bonds markets, the inclusion of real assets within a portfolio can protect against unexpected downturns and provide more diversification, improving a portfolio’s risk-adjusted returns.