Table of Contents
As we have seen by analyzing the law of demand and supply, it is very important to understand how demand and supply behave with respect to one another and with respect to the economic environment. In this case, we will analyze how asset demand is determined.
In the first place, it is important to remember what an asset is.
An asset is a piece of property that has the quality of a store of value, which means that it is a repository of purchasing power available over time and that allows the holder to save purchasing power from the time income is received until the time it is spent on the market. This means that the actors that participate in markets where assets are traded, tend to be faced with the question of whether to buy and hold an asset or whether to buy one asset rather than another, and their decisions will be highly influenced by the following key factors: wealth, expected return, risk, and liquidity.
Wealth can be considered as the sum of the total resources owned by an individual.
Usually, it is positively correlated to asset demand, in fact, an increase in wealth allows individuals to buy more assets than before, which means that holding everything constant, an increase in wealth raises the quantity demanded of an asset.
This factor must be taken into account while making a decision about whether or not to buy a certain asset, in fact, we decide to purchase a certain asset when the returns that we expect to earn are satisfying.
For example, suppose that General Motors bonds have an expected return of 10%, and one day it rises unexpectedly, to a return of around 15%. It is reasonable to think that demand for those bonds will increase with respect to other assets, holding everything else constant.
On the other hand, there could be an increase in demand for General Motors bonds even if their return stays at the same level (10%) but the value of similar assets falls because they immediately become more desirable.
The level of risk of an asset is also another factor that can determine asset demand. However, risk, which in this case is strictly linked to the level of uncertainty about the future performance of an asset is hard to assess and to estimate, in fact, at any given point in time we have available only data about the past performance of a certain asset which certainly cannot help us to estimate how that asset will perform in the future.
However, not all assets behave in the same way, some of them are inherently more volatile and therefore their performance is much more uncertain than other assets, for example, stocks are generally a lot more volatile than U.S. Treasuries. Risk is not always bad, in some cases an investor may decide to buy an asset that has future returns that are more uncertain but that can give also better returns, for example that 50% of the times will return him 20%, and the other 50% of times will make him lose 15%, instead of buying a more stable asset that 95% of times returns 2% and 5% of times returns nothing.
Nonetheless, it is also true that most people tend to be risk-averse, which means that holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall.
Finally, the last factor that determines asset demand is liquidity, that is how quickly the asset can be converted into cash at a low cost.
For example, a house is not a very liquid asset because if you decide to sell it, it may be hard to find a buyer quickly, especially if you do not want to sell it at a big discount. On the other hand, financial assets like stocks and bonds most of the time are very liquid assets because they are traded in markets where there are plenty of buyers and sellers.
The fact that an asset is highly liquid makes it more interesting because you know that in case you will find yourself in need of money for various purposes you can obtain it easily by selling that asset, while with less liquid assets you know that it may be hard to sell them in a short period of time and at a decent price.
Therefore it is fair to say that, holding everything else unchanged, the more liquid an asset is relative to alternative assets, the more desirable it is and the greater quantity demanded will be.
Theory of Portfolio Choice
The theory of portfolio choice summarizes all the determinants that we have seen before, and tells us how much of an asset people will want to hold in their portfolios, and it states that:
- The quantity demanded of an asset is positively related to wealth;
- The quantity demanded of an asset is positively related to its expected return relative to alternative assets;
- The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets;
- The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.