Friday, February 14, 2014

Socially Responsible Investing

Before reading further take a moment to consider, what is the purpose of investment?

Most people probably would reply that investment is a means to acquire wealth and income.  On the individual level they're most likely correct.  Few people invest with hopes of losing their nest egg.  But on a social level what purpose does investment serve?  

The answer likely isn't terribly intuitive for non-economists.  Investors, through their self interested wealth creation should be allocating capital to firms that will use it most efficiently. For example, if Bill's company has a fantastic new software product that people will find useful he should be able to sell it for a decent profit.  This prospective profit should allow Bill to attract investors who will provide the funds for Bill to fully develop and distribute his product.  The end result is that Bill and his investors become wealthier and society benefits from a product that improves everyone's lives.  Everybody wins and everyone is happy.

This pattern has been followed in various forms for centuries.  Spice traders would provide funds for caravans to travel eastward, buy spices and return them to their homeland. Again, society benefits from the spices they desire and the investors and firms profit.  Kings and Queens would provide ships and crew for explorers mapping far off continents.  The explorers opened up new lands for society to develop and returned with new riches to fill the coffers of their investors. To generalize the pattern, investors provide capital to firms or individuals who then transform the capital into a good which society values more than the capital. The firm collects the excess valuation (profits) and passes it on in part or whole to the investors.

Contrast this pattern with gambling. Gambling, much like investing, has the same goal to the individual, wealth accumulation (although hopefully the ultimate goal is entertainment rather than income). However, gambling provides no benefit to society.  It is simply the semi-random exchange of funds between two parties, the gambler and the house. Although a gambler and investor both give funds to another party in the hope of great return, the gambler has no thought to a casino using funds productively or efficiently.  An investor meanwhile will only provide funds to a firm which he believes has a profitable purpose and effective means to accomplish it's purpose.

This brings us then to the concept of speculation, the investment in a firm or commodity simply due to the belief that the equity will appreciate in value.  An investor who buys iron with the belief that iron will become more valuable due to possible shortages performs no service to society.  Ultimately iron mining firms will seek investment to expand operations and thus fulfill societies iron needs.  But the investors that buy shares in the firms will be allocating capital optimally (from a societal perspective) whereas those that buy iron accomplish nothing but driving prices higher.  Both (assuming an increase in iron prices) will profit, but those that buy iron will only benefit themselves.

Speculation is at best attempting to outguess the market. Whereas investment is the efficient allocation of funds in a free market.  It's perfectly reasonable to invest in facebook because you believe the management will use the funds productively. However, investing in facebook simply because you believe others will drive up the price accomplishes nothing but the gain or loss of personal wealth.  Of course, on the individual level most people are more than satisfied with "just" the gain of personal wealth.  Still, in an ideal world investors would always gain profit at the same time they're helping keep the economy moving forward.

That's all for this week. Until next time stay safe and rationale. 

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