Investment and Savings

"You're a part of something here, Bud. The money you make for people creates science and research jobs. Don't sell that out."
--Lou Mannheim to Bud Fox (Wall Street)

In a previous post we examined the relationship between income, consumption, and savings. Savings is the difference between income and consumption. Lower savings increases risk of a lower standard of living in the future. Dissavings, or borrowing so that consumption exceeds income, magnifies risk of lower future standard of living.

To improve future income prospects, individuals can allocate savings towards investment. Investment involves the utilization of resources as capital for generating income. Investments typically take the form of equity (full or partial ownership of a business to obtain a share of future profits) or debt (lending money to others to obtain a future interest payment).

Because it requires speculation about future returns, deploying resources as investment capital is by definition risky. Businesses may fail. Borrowers may default.

Many folks tend to equate investment with savings. It is true that investment capital comes from a pool of unconsumed resources. But investment capital may be lost as a result of poor investment decisions. True savings, on the other hand, carries little potential for loss.

The original mathematical expression of the relationship between income (N), consumption (C), and savings (S):

N = C + S

may be better written as:

N = C + (I + s)

where S becomes a blend of resources allocated towards investment (I) and true savings (s).

Individuals who consume much and save little might mitigate risk of lower future living standards by investing. If the investment decisions are good ones, then higher future incomes may be realized that compensate for the lack of savings.

However, investment itself carries risk. If investment choices are bad ones, not only are future incomes not improved, but capital is lost. In such cases, savings are reduced, and probability of lower future living standards increases rather than decreases.

Let's connect these concepts to a couple of practical applications. First, it is often proposed that individuals should 'save' 10-15% of their annual gross incomes in retirement accounts. To the extent that those funds are allocated towards stocks, mutual funds, corporate bonds, and other risky assets, these allocations constitute investment (I) rather than savings (s).

As many folks are realizing after opening recent quarterly 401(k) statements, these investments can result in losses. Lower future incomes, and lower future standards of living, have become more likely for those who have made poor investment decisions with their retirement 'savings.'

The second application streams from the following scenario. Suppose individuals consume more than their present income by borrowing resources from others. To mitigate risk of a lower future standard of living, the individuals borrow additional resources from others and invest in a manner that they hope will increase future income. Unfortunately, the investments are poor and most of the borrowed capital is lost. Prospects of a lower future standard of living have been magnified by borrowing money from others and by poor investment choices.

Now, government officials propose the following. Let's borrow even more resources and collectively invest in the same 'distressed' assets (mortgage backed securities, equity in companies such as American International Group (AIG, etc.) that individuals lost money on. If these assets become 'less stressed' in the future, then perhaps they can someday be sold at a profit.

Borrowing in an attempt to recover losses realized from poor investment of past borrowed money.

Such dysfunctional behavior is what made Kahneman & Tversky's (1979) prospect theory a Nobel winner.

no positionshneman, D. & Tversky, A. 1979. An analysis of decision under risk. Econometrica, 47: 263-292.