Wednesday, 1 December 2010

Why most expensive items should not be called investments (Part 2 of 3)

When it comes to applied economics, the most important paradigm is not mathematical. Understanding it can help you make better decisions and, above all, avoid many traps in your private and business life. If you choose to study only one thing about economics, let me suggest that you learn to tell the difference between consumption and investment, in particular:

1. Investments are not characterized by a high acquisition cost. A large house on the beach that you buy to spend your summer holidays every year can be expensive, but is not an investment, since it does not produce you any income. In comparison, a small low-cost apartment that you rent out to tenants does constitute an asset.

2. Investments are not defined by their long durability. A refrigerator that you purchase for your kitchen may last 10 years, but does not generate you any income. Such acquisition is not an investment. In contrast, a set of liquor glasses that may last 3 years is an investment if you buy them for use in your restaurant.

The lesson is that the aspect that creates the distinction between consumption and investment is psychological. Classifying buildings automatically as investments without considering their purpose may lead to wrong decisions and expensive errors.

To be continued in Part 3


[Image by Christopher under Creative Commons Attribution License. See the license terms under]