Wednesday, March 2, 2016

Investment List Question Partially Answered

A few days ago I posted two partial lists of investments and posed the question to identify the key distinction between them. Here is the answer.

The key distinction is cash flows. I contend that the assets in list #1 meaningfully generate cash flows while the assets in list #2 do not.

Consider what a cash flow is: a stream of payments going (flowing) to asset owners generated by the asset itself. This does not include money or other assets taken in exchange for ownership of the asset. That trade value is important, but using it to evaluate current (present) value must ultimately rely on guess work--namely guessing what someone in the future will pay for it. Using cash flows is a very useful method to value assets and get around this resale (aka, "greater fool") theory of value. 

Once you have a guess as to what cash flows will be for a given investment, all you need to do is apply a discount rate, sum the results, and viola you have a net present value (current price). And more importantly you now have a method to compare various assets' valuations. Of course, it is not quite that easy. We have to guess/argue about the timing and amount of cash flows, and we have to appropriately guess what discount rate to apply for a proper time-value of money adjustment. But there is even more complication.

There is a tension between my logic and my lists. The implied rent payment one saves by owning their home is fairly vague while the returns from turning copper into the product of electrical wiring is not so vague. Conceivably, if you define "cash flow" broadly enough, everything has a potential utility value that could be described as a cash flow (or in cash-equivalent terms). For this reason I said list #1 meaningfully generated cash flows. I am assuming a reasonableness standard we can generally agree to. 

As such, I don't view gold as an investment in the same realm as I view, say, a share of stock. Gold's value is too reliant on the presumption that someone else will want to buy it at a later date. (Here is some of what the Oracle has said about gold. Read at least #4.)

My two lists of investments are not intended to be uniformly separate. Each item to varying and changing degrees exists on a continuum. Think of it loosely as the Beanie Babies to U.S. Treasury Bonds scale. The "cash flow" from Beanie Babies is only the joy one may get from holding one and the opportunity to sell it down the road. The cash flow from UST bonds is semi-annual interest paid and the promise to mature at par value. Where do you put gold on this scale? As you answer that question for each asset, you start to see a large gap forming naturally separating the two emerging lists of investments. 

P.S., When I first started to answer the question, I fell down a deep rabbit hole that took me quite a while to escape. Read on if you'd like to witness the journey. Bonus points for realizing the subtle point that creates the difference between the answer above and the answer below.

Consider what a cash flow is: a stream of payments going (flowing) to asset owners generated by the asset itself. This does not include money or other assets taken in exchange for ownership of the asset. Ultimately, for an asset to have value, it has to be intrinsically valuable to someone. Take a bond for instance. A bond is intrinsically valuable because it generates income in the form of interest. And that interest (cash) has value because it can buy stuff like beanie babies and food, which are intrinsically valuable because . . . because my daughter likes beanie babies and she and I both need food. . . okay, we might have a problem here. If you didn’t catch the circular logic, go reread that.

Any time you hear “intrinsic value”, your spidey sense should start tingling. That concept suffers from what I call the artificial logical stopping point. It is the fallacious attempt at halting what becomes “turtles all the way down”. In a chain of subjective value propositions we assert at some point that one of those values is so esteemed, so important, that it is an intrinsic value. If that sounds arbitrary, it’s because it is arbitrary. One can always challenge the leap to the intrinsic showing that leap to be invalid. Objectivism philosophically solves this conundrum by basically rejecting the need for an intrinsic value concept. I believe that is the correct way to conceptualize value—value is the relation between the object valued and the individual valuing it, but can I reconcile it with my belief that the two lists are distinguished by the presence of cash flows? I can because of what I am arguing cash flows are and what they are useful for... [this is where I caught my mistake and began anew].