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There are three contexts of investment relevant to the social sciences. First, there is the authoritative investment of endowing a person with social and institutional authority, power, or privilege. Second, a financial investment consists of the production or purchase of an asset in order to obtain its yield, such as interest from bonds. Financial investments involve the exchange of one paper asset (money) for another asset—for example, stocks, bonds, and real estate. Third, an economic investment is the production of some new asset (new plant and equipment, expansion of inventories, new residential construction, reputation) or the creation of new laboring ability (human capital).
The methods of authoritative investing are delegation, inheritance, and usurpation. In a democracy, authoritative investment endows officials with authority in accord with the rules of elections and appointments to office. That authority vests the officials with power and privilege as legally delegated to them from the people, as ultimate sovereignty rests with the people. In a kingdom, royal authority is usually handed down by inheritance, and inheritance also invests heirs with titles to private property. In a dictatorship, the chief of state invests himself or herself with ruling power, and criminals too vest themselves with power over their victims, such as when they illegitimately take property from their victims.
In finance and economics, investing is distinct from speculation. Speculators buy assets with the expectation of gaining due to shifts in supply and demand. Speculators buy shares of stock in a silver mining company if they expect the demand for the metal to increase. Investors buy the stock in order to obtain the dividends from the profits of the firm. The purchase can, of course, include both investment and speculation.
The yields of financial investments include interest, dividends, rentals, capital gains, and business profits. Dividends are a share of corporate profits from stocks or a mutual fund, while interest is obtained from loaned funds, such as bonds and savings accounts. Capital gains occur when an asset sells for a higher price than its initial price of purchase. The return to an investment can also be in the form of the retained earnings or profits of a corporation.
Economic investment consists in the production of capital goods and the enhancement of human capital, the education, skills, and training obtained by workers. A capital good can be intangible, such as when a company invests in advertising in order to create goodwill and reputation capital. Human capital includes relationships with other persons, which is more specifically referred to as social capital. A person also invests in human capital to be a better consumer, such as learning music appreciation to enjoy symphonic music, which is more specifically referred to as cultural capital.
The inputs of production are classified as three “factors,” land, labor, and capital goods. Land means natural resources, existing prior to and apart from human action and its products. The purchase of land is a financial but not an economic investment. Capital goods, such as buildings, machines, and inventory, are products whose value is not yet consumed. Improvements to a site, such as clearing and leveling the surface, are included in capital goods. A bond is a loan of funds to a borrower who pays interest for the duration or term and returns the funds when the bond matures. The bond might be used by the seller to produce capital goods, but the bonds are not in themselves produced goods and so are not an economic investment.
Technology is embedded in both capital goods and in human capital. If there is no change in technology, investments eventually have diminishing returns. Given a fixed area of land, fertilizer can increase the yield of a crop, but as more and more fertilizer is added, the extra amount of fertilizer provides a reduced amount of extra yield. If one keeps adding fertilizer, eventually the marginal product or extra yield becomes zero and then negative—too many cooks spoil the broth.
An increase in the amount of a variable input eventually yields diminishing returns when some other input is fixed. However, there can initially be increasing returns from more investment if there are network effects that increase the value of each good. For example, if fax machines are more widespread, then a machine has higher usefulness because it can send and receive messages from more units. Capital goods can also complement other investments so that there are at first increasing returns. But such increasing returns themselves eventually diminish. Much of the historic increase in productivity has come not just from an increase in the stock of capital goods but from better technology. There are no diminishing returns to better technology.
Both capital goods and human capital depreciate; they lose economic value due to “wear and tear” as well as from obsolescence and uncertainty. Gross investment is the total amount of production of capital goods and human capital, while net investment equals gross investment minus depreciation. In national income or output accounts, typically only investments in capital goods are included in the investment category in calculating gross and net domestic product.
Efficient Financial Markets
The purpose of investment is to maximize future consumption, thus to obtain the greatest increase in future yields. The optimal investment has the highest riskadjusted rate of return. Risk means the possibility of loss with a known probability. Uncertainty means the possibility of change with no known probability. The optimal investment has the greatest net present value, the value at present of a stream of future income minus the initial outlay and other costs, discounted by the relevant interest rate.
Even though subject to large fluctuations, financial markets tend to be rather efficient, meaning that the prices of financial assets encompass the known public information about the asset, the relevant industry, and the economy. The seller is pessimistic, believing the price will fall, and the buyer is optimistic, believing the price will rise. The price is the midpoint between the pessimists and the optimists. On the average, one who buys the stock will do no better than the market average. In fact even most professional financial managers and advisers have not performed better than market averages in the long run.
The concept of efficient markets does not imply that prices are perfect reflections of future earnings and economic conditions but rather that it is not likely that one will systematically profit from market timing or stock picking. It does imply, however, that riskier assets will normally have a higher return to compensate for the greater possibility of loss or of the greater fluctuations that make the price at some future date less predictable.
The theory of efficient markets for financial investments is called modern portfolio theory (MPT). It prescribes that an investor should seek no more than to match the averages of the various sectors of financial markets. However, the relevant knowledge has to be utilized by some investors or speculators in order to set the efficient price in the first place. Research into companies, industries, and the economies must offer some reward, and in an efficient market this reward would be commensurate with other gains.
Efficient markets also do not preclude some financial analysts from having insights and analysis superior to those of others in some types of markets and economic conditions. Not only is there great uncertainty about future economic variables, such as inflation and interest rates, but there is also a lack of consensus about many aspects of economic theory, such as business cycles.
Savings And Investment
Savings equal income minus consumption. In economics, consumption means the using up of economic value, like fire consuming wood. Production means the creation of economic value. The consumption of a house consists in its depreciation. The purchase of a car has the same economic characteristics; the car is an investment, and its consumption is the depreciation. From the economic point of view, all goods that one buys are investments until they are consumed, although in national income accounts, outlays other than for a house are counted as consumption.
Savings are either invested or kept in money. Few people normally hoard large amounts of cash, so ordinarily people save money in a financial institution, such as a bank or a money market fund. These institutions in turn loan out their money. Money borrowed for consumption offsets some of the money saved, and the rest is spent for investment. Thus in general the net savings of households is either invested or kept as money in the banking system. Banks are legally required to have a small portion of their deposits held in reserve, and they loan out the excess reserves.
Investment comes from savings, but the amounts households plan to save do not necessarily equal the amounts that investors seek to borrow. If investors seek to borrow more than what is available from savings, then the market rate of interest will rise, reducing the amount of intended borrowing while increasing the amount of savings. If the supply of savings increases, then interest rates fall as bankers seek to loan out the excess reserves. The market rate of interest thus has an important role in the economy: it equilibrates savings and investment so that the quantity of loanable funds supplied by savings equals the quantity demanded for investment by borrowers.
The total savings in the economy also includes government savings, government revenues minus government spending. A government deficit that is used for consumption creates negative savings, a reduction in national savings. Government bonds can compete with corporate bonds, raising interest rates and “crowding out” private investment that would have taken place unless the funds are borrowed from abroad or private savings increase. Unless the deficit spending is used for productive investments, such as infrastructure, the government deficit can burden future generations by reducing private investment and also by making future taxpayers pay interest on debt that does not benefit the present generation.
Investment and the Business Cycle
Investment fluctuates much more than consumption. Major changes in investment drive the business cycle as recessions occur after a large decline in investment. Investment declines because entrepreneurs expect lower profits, and profits usually decline either because costs have gone up or because the demand for goods is expected to fall. In some economic models, the accelerator principle asserts that investment depends on the annual increase in output and the capital needed to produce the increase. The more fundamental explanation is that savings, interest rates, and expectations about the future determine the amount and the mix of investment.
Lower real interest rates induce more investment in fixed capital goods, such as real estate construction. When the monetary authority expands credit by injecting money into the banking system, the interest rate is lowered as the banks seek to lend out the extra money. Later, to prevent excessive inflation, the monetary authority then reduces the rate of money growth, and interest rates go back up. Investments profitable at the previous lower interest rates are no longer profitable, reducing investment and also wasting capital that would have been better invested in goods with a faster turnover.
Meanwhile the lowered rate of interest also makes it attractive to invest and speculate in real estate. Much of the benefit of economic growth is soaked up by higher rentals and land values due to the fixed supply of land and implicit subsidy to land values from public works not financed from the generated rents.
Speculative demand adds to the demand for use, pulling up real estate prices. At the peak of the boom, higher interest rates plus higher real estate costs diminish profits, and industries such as construction slow down. The diminishing investment reduces demand for other goods, and the economy falls into a recession. Real estate prices and interest rates then fall, and the reduced costs eventually lead entrepreneurs to invest again, and then the economy recovers.
Taxation, Regulation, and Investment
Income taxes reduce investment by taxing the interest, dividends, profits, and capital gains from savings, enterprise, and investment. The effect is more severe when, as in the United States, the income tax is on nominal gains and nominal depreciation, ignoring inflation, thus taxing the principal as well as the gain. This excess burden has been recognized by providing for tax sheltered savings, such as individual retirement accounts (IRAs), by lower tax rates on capital gains, and by investment credits for businesses. Nevertheless, much of investment remains subject to taxation. Sales and value-added taxes have similar excess burdens. Some economists advocate shifting public revenues to pollution charges, user fees, and rents of natural resources to avoid excess burdens on investment in both capital goods and human capital.
Regulations can enhance markets, such as when they prevent fraud, but they also impose costs similar to taxation. Excessive restrictions and reporting costs can create a deadweight loss similar to taxation, a reduction of investment not offset by social benefits.
- Elton, Edwin J., Martin Gurber, Stephen Brown, and William Goetzman. 2006. Modern Portfolio Theory and Investment Analysis. 7th ed. Hoboken, NJ: John Wiley.
- Haugen, Robert A. 2001. Modern Investment Theory. 5th ed. Upper Saddle River, NJ: Prentice Hall.
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