This article is an excerpt from the Shortform book guide to "Basic Economics" by Thomas Sowell. Shortform has the world's best summaries and analyses of books you should be reading.
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What is a financial investment? Why do people invest their hard-earned money in spite of the unpredictability of return and other risks?
Investment is the sacrificing of money, goods, and services today to have more valuable money, goods, and services in the future. Because the future is unknown, investments necessarily involve risks, which must be compensated to make it worthwhile for people to undertake the investments.
In this article, you’ll learn about the types of financial investments, how they work, and their associated risks.
Financial Investments
Investments pool resources from many stakeholders to finance large projects that would not be possible with few investors. Think of a government bank selling bonds to build a hydroelectric plant, or a company raising funds to broaden access to its product. Countries without financial institutions cannot mobilize capital from a mass of individuals to make large investments, and they tend to be poorer.
Profits from banking and investments have been decried as “unearned income,” merely skimming profits off of hard labor. This stigma has led minorities outside the existing social system to lend (e.g. Jews in Europe, Chinese in Southeast Asia). However, this stigma ignores the high chance of business failure and the many discretionary decisions required for investment success.
We’ll discuss the following types of financial investments and their associated risks: loans and bonds, stocks and venture capital, and speculation.
Loans and Bonds
In loans, interest rates compensate lenders for risk and for the delay in receiving money back. Money is more valuable today than it is in the future – at the very least, you could earn interest on money in a bank, or invest it in the stock market. You may also die and lose on the opportunity to spend that money; or the bond issuer may go bankrupt.
Therefore, people are willing to buy bonds (lending their money to the bond issuer) at a certain interest rate considering the above factors. If you are willing to part with $100 to earn $104 a year from now, this sets your interest rate at 4%. Naturally, in the bond market, people bid different prices based on what the bond is worth to them.
Higher interest rates lead people to save money and decrease borrowing, and bond prices go down because there are more attractive places to put money. Likewise, low interest rates lead people to spend money and borrow money to spend today, and bond prices go up since they become relatively better investments.
Payday loans appear to have astronomical annual rates, but they are rarely held for as long as a year – they’re meant to be bridge loans to the next paycheck. The overhead fees for each small transaction also inflates the apparent rate.
Laws that make loans difficult (forbidding interest or collecting on debts) limit those loans from being made in the first place.
Stocks and Venture Capital
Stocks tend to have higher rates of return than bonds because of their variable rate of return, while bonds have guaranteed returns. Consider two occupations – one that pays a regular $50k a year, and another that pays $10k one year and $90k the next. You’d likely want to be paid more for the latter. Analogously, people will not take the risk of buying stocks without being compensated above the safer alternative of bonds.
(Shortform note: this might suggest that if an entire nation becomes comfortable with long-term time horizons, as with the growing popularity of passive investing, the rate of return for stocks will go down.)
Interestingly, the risk varies with time involved. In the short term, bonds are likely safer than stocks; but at 30 years, the risk of inflation threatens the value of bonds, while stock prices tend to rise with inflation.
Entrepreneurs with immature businesses are unable to issue bonds or secure loans, given the high risk of failure. Thus they tend to raise money by selling stocks instead. As a whole, the venture capital industry does not lose money, suggesting it does not waste the resources of the economy, even if individual venture capitalists have vastly different returns.
Speculation
Speculation involves buying things that do not yet exist or whose value is undeterminable, such as buying stocks in new unprofitable businesses, exploring for oil, or buying scripts for movies that may not be made.
Speculators reduce risk for the counterparty, for a price. For example, a speculator may sign futures contracts to buy or sell corn at prices fixed in advance, so that the corn farmer may concentrate on farming and rely on this certainty to make his own investments. Speculators are better able to bear these risks due to more sophisticated assessment of risk, ability to ride out short-term losses, or diversification.
Naturally, for the speculator to make a profit, the speculator must on average pay the farmer less than the market price at harvest time – this gap is the value of reducing risk for the farmer.
Speculation is often considered akin to gambling, but gambling is creating a risk that would otherwise not exist (like Russian roulette). Speculation attempts to minimize inherent risk.
Related: insurance companies pool risk from large numbers of people to reduce risk at the individual level. Insurers have vast amounts of capital and can last beyond human lifetimes, enabling them to absorb the variations among individuals.
Capital Gains
Given inflation, taxing capital gains is questionable because it considers the absolute cash increase, not the relative value of money. If the interest rate is 4%, and someone buys a $10,000 bond and receives $10,400 a year later, she will be taxed for the gain in $400. But if inflation were 4% in the same year, the two amounts of money would be equal with no reward for buying the bond. Thus capital gains taxes are controversial.
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- Why we use money, rather than bartering our services with each other
- Why some nations prosper, while others stay poor despite vast natural resources
- How rent control might actually reduce housing supply and quality
