Mommy, Where Do Investments Come From?

By Brad Thomason, CPA

 

Have you ever stopped and wondered where investments come from? By which I mean, why they exist in the first place?  Most people have expectations of earning a return, and if we’re being honest we sort of feel like we deserve one, right?  Well, why is that?  What is it about the world that sets the stage for making that a reasonable expectation?

Simply put, investments are an outgrowth of the fact that resources are not evenly distributed.  Somebody wants something that’s different than the situation they already have, and are willing to pay to get it.  This is the base proposition underpinning what we think of as investments.

There are all sorts of ways of classifying investments, but for purposes of this discussion, I’d propose the following 2-type framework.  There are investments that arise when A has capital, B needs capital, and B is willing to pay A something to use it.  Then there are investments when A and B both have something of value, but one of them doesn’t have the terms they want and the other is willing to trade terms in exchange for something in return.

Examples of that first type are the ones most commonly associated with what we think of as conventional investments.  Stocks and bonds are the workhorses of this category, and exist for no other reason than to make connections between those who have capital and those who have a productive way to put it to work.  If the folks with the money were the ones who also had the best ideas and opportunities for using it, there would be no need for modern financial markets as we know them.  But as mentioned earlier, things are not distributed in that way.  Due to the fact that capital and opportunity do not travel through the world in lock-step, there has to be a means to join the two together.  Capital markets (and to a lesser degree banks; though banks are really more about financing liquidity than the actual capitalization of ventures) create the means for symbiosis between the two camps; and investments are the evidence of that relationship.

The second category exists for a different reason.  If we want to think of that first type as a relationship between haves and have-nots, this second category is one that involves only the haves.  One party has something of value, but it doesn’t meet the profile for what they want.  Maybe they have a lump sum, but would prefer a stream of income.  Maybe they have a fixed rate, but would prefer one that floats.  Maybe they have a concentration of one type of asset and would like to trade some of it for something else for diversity‘s sake.  Maybe they wish to alter a certain holding’s exposure to taxes or some other sort of liability.  As you can see, the range of possibilities is a wide one; but the central point is that you have someone who already has something (i.e. doesn’t need to use someone else’s capital), it just doesn’t quite conform to what they want.

 

Here are some examples:

A farmer wants to know that he will get a fixed price for his corn come harvest time, and a speculator is comfortable taking on the risk that prices could go up and he’ll net a big profit.  So a futures contract is created.

A pension fund owns a pool of variable rate mortgages but would prefer to have a steady rate of interest.  So they enter into a rate swap agreement with a counter-party who is comfortable with the fluctuations.

The owner of a life insurance policy is facing the prospect of escalating premiums as they get older.  They do not want to have to allocate their retirement income to this cost, but neither do they want to stop paying on the policy and lose the benefit of what they already pay in.  So they sell it to an investor who a) has plenty of cash and can handle the future premium payments, and b) can afford to wait for a pay off at some point in the distant future when the insured passes away.  The insured gets a recovery of what they’ve put in and then some, in the form of lump sum of extra cash to use right now.  The investor earns a return equal to the difference of the purchase price plus premiums and the death benefit.

 

I could go on, but you get the picture.  Owners of valuable things working together to swap terms.  The two most common terms are those that deal with fixed vs variable rates, and $$ now vs $$ later.

A final note before we leave this topic.  Making the determination between which type of asset you are dealing with is helpful in terms of assessing the desirability of a particular investment.  How?  Well, if you are dealing with one of the first category, where a fee is being paid (in the form of interest, dividends, whatever) for the use of capital for productive purposes, you want to make sure that the activity is actually going to be a productive one.  With the second type, whether or not productivity is going on may not be an issue.  Rather, the underlying value of the assets and the other party’s ability to make good on the swapped terms become the focal points.

But either way, it is important to realize that investments of any type exist because another party is lacking something they need.  If you provide it, you should get paid for that service.  On the other hand, if what you are doing doesn’t really make much of a difference to anyone else (like sticking $10,000 in a CD at the bank), it should probably not come as a surprise that you don’t get a whole lot in return.

And that’s where investments come from.

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