Financial Mathematics Text

Friday, August 2, 2013

Keynes on Investment, Speculation and Uncertainty Part I

John Maynard Keynes is, as an economist, either well-liked or greatly despised. I suspect a lot of that dislike is a result of the neoclassical synthesis which had more to do with Hicks and classical economics than it did with Keynes but all of that are just mere footnotes.

Keynes' most well known contribution is The General Theory of Employment, Interest and Money or sometimes just referred to as The General Theory.

If you've ever tried to read The General Theory you probably noticed it's not exactly an easy book to read. Part of this I think has to do with paradigm shifting. Often people who are rethinking the way we think about a particular discipline or subject have a hard time conveying their ideas. They either have to invent new terminology (which they may do a poor job of showing how to use that terminology) or they use old terminology in new ways (which comes with the baggage of the old ways of using that terminology.) Later thinkers then have to attempt to interpret what's actually saying and apply it which is often no easy task. But I digress.

The chapter that was probably most lucid in Keynes' General Theory was Chapter 12: The State of Long-Term Expectation. That's going to be the focus here today.

Keynes is primarily concerned here with capital assets (factories, machine, equipment, etc) which have the capacity to generate revenue (say by producing a product that can be sold for consumption). But he also addresses common stocks as well. After all, stocks represent a residual claim on the firm's capital assets and the cash flows that can be produced from them.

One critical question to think about, and one that Keynes is concerned with here is this:

Should I invest or should I hoard?1

To answer this question there are three things you need to consider:
  1. How much will it cost me to produce (or purchase) this capital asset?
  2. What kind of cash flows can I obtain from the assets?
  3. What required rate or return do I need to obtain?
Because ultimately you want the value of the cash flows discounted to the present (taking into account the time value of money) to be at least as high as the cost of that capital asset.

Keynes points out there are there things we know with some degree of certainty and things which are quite uncertain:
The considerations upon which expectations of prospective yields are based are partly existing facts which we can assume to be known more or less for certain, and partly future events which can only be forecasted with more or less confidence.
Keynes gives examples of each:

More or Less Certain More or Less Uncertain
  • Current (type and quantity of) stock of capital assets
  • Current demand for goods
  • Current price of capital assets
  • Future (type and quantity of) stock of capital assets 
  • Future demand for goods (as it varies over time
  • Future costs as it varies over time (e.g "wage-unit")

Whether or not an investment is worthwhile is dependent on a lot of different variables many of which are quite uncertain. This leads to a key observation:

Investors must invest under conditions of uncertainty.

The question then is how this is done.

Keynes points out that our ability to actually projecting these future uncertainties even ten years out is, perhaps, not very good. He also contends that it doesn't play much of a role in actually determining investment (or those players that do are "often so much in the minority that their behavior does not govern the market".)

What is required, psychologically speaking, Keynes claims is confidence. As the state of confidence varies, investors will be less willing to take a chance. But we still have that uncertainty problem. As Keynes notes:
If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.
So obviously investment takes place (and it's a good thing it does) the question is, if not a result of cold calculation, how does it take place?

Keynes claimed that it's a matter of convention.
The essence of this convention [ . . . ] lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change [emphasis added].
This goes back to the old problem of induction. Of course we don't necessarily believe that things won't change. But if we don't have any specific information that will tell us how things will change, simply assuming the current state of affairs will remain roughly the same makes for a convenient standard even if it is unjustified epistemologically speaking.

And that approximates how valuations take place. We start with what we know such as existing prices, demand, expenses, cash flows and growth rates and use that to estimate future prices, etc (allowing for adjustments for any other information we might have about future conditions.) We certainly don't know any of that but what alternative do we have?

For more, see Keynes on Investment, Speculation and Uncertainty Part II.

Also see this related post: Uncertainty and Margin of Safety

1If you weren't aware, this question was actually inspiration for a punk rock song.

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