Monday, November 23, 2009

Investing in Semantics

“The reason we have such a comfortable relationship, is that we both know, there is no chance of our ever having a relationship.”

I hate words that can mean two different things even in the same context. Right now I’m thinking of the word “investment.” As a macroeconomist working in an asset management business, I feel obliged to contradict myself when I use that word.

It’s kind of like the way soft core adult performers use the word “porn.” I don’t do investment. No, never. Not me. If you saw a picture of me building a factory, I guarantee you it was Photoshopped!

And just like with porn, there are gradations. After all, buying bonds is just a way of lending money. Right? Not really investment. Just cheesecake. But stocks, on the other hand.... It doesn’t matter what they’re doing or not doing; if the financial statement’s naughty bits are exposed, then it’s investment!

Leaving aside the analogy, though (because I’m still hoping for a G rating), I do see some logic to the ambiguity of the word “investment.” In general, to invest means to acquire an asset that is expected to provide returns or benefits in the future. The difference is in your frame of reference.

If your frame of reference is the individual household, then stocks and bonds are investments. When a household purchases a stock or a bond, they do so because they expect it to provide returns in the future.

If your frame of reference is the whole world, then stocks and bonds are not investments. Clearly, the world as a whole does not expect to receive future returns simply because one entity borrows money from another entity. And the world does not expect to receive future returns simply because one entity expands itself by selling a partial interest to another entity. And the world certainly doesn’t expect to receive future returns just because our client purchases that partial interest from the entity to whom it was originally sold.

In the global frame of reference, for something to be investment, it must involve actually creating some new value. If someone builds a house or a factory, the world as a whole has accumulated some wealth in the form of a new asset. Or if an existing factory turns out machines to be used in other factories or offices. That’s “hard core” investment. (Am I risking my G rating by noting that even software is a hard core investment?)

If you take countries – rather than households or the planet – as your frame of reference, then stocks and bonds are sometimes investments and sometimes not. Japan isn’t accumulating new wealth when Mr. Fujimoto buys shares in Sony. But Japan is accumulating new wealth when Mr. Fujimoto buys a US Treasury bond. (Theoretically, anyhow. I know there are those who would argue that buying dollar-denominated assets amounts to throwing away wealth rather than accumulating it.)

In my position, unfortunately, I’m occasionally obliged to shift frames of reference in mid-sentence. Oh, well. I have more than one relationship with the word “investment.” Everyone knows you have to be very careful if you’re trying to be in two relationships at once.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


Mike Hunter said...

Good post! As a finance major who's pursuing a minor in applied economics this confused me at first. Whenever I heard the world "investment" in an economics class I would think of debt and equity; instead of property plant and equipment.

But I do have one question though. Could a Merger and Acquisition be considered an investment in the economic sense of the word if it created greater output.

For example firm #1 notices that firm #2 is poorly run and thinks that it could do better, further; firm #1 believes that that if it can takeover firm #2 it can increase the level of output being generated by both firms capital inputs though a synergistic effect.

Assuming that firm #1 is correct in its assumptions would this constitute an 'economic' investment even though no new capital was initially created because of the transaction?

Andy Harless said...

Mike, yes, the real world is always more complicated than the ways we try to describe it. In your example, there is clearly some "economic" investment taking place (although it probably wouldn't be the entire price of the purchase). In terms of what will actually show up in accounting statements, the only new net investment is probably in "goodwill". But in economic terms, you could imagine firm #2's capital as having a lot of unrecognized "depreciation," in the sense that, in the hands of bad managers, its productive value is less than its book value. When firm #1 buys it, the capital gets, as it were, "un-depreciated," so there is some net economic investment. It's as if part of the purchase price is for the existing, unproductive capital (just financial investment), and the rest of the price is for improvements made to the capital (economic investment).

Another example I thought of while writing the post: selling stock to avoid the deadweight cost of bankruptcy. If a company has a viable business but is in financial trouble, and then it issues new stock, you actually are creating new value by buying the stock, because the company is more economically valuable as a financially sound going concern than as a candidate for reorganization. But, like the quality of management, the financial soundness of a company is something that is hard to measure, so it won't show up in the national accounts.

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