Thursday, February 01, 2007

investment time horizons

This blog entry will put forward a case for a radical redesign of investment time horizons.

What are investment time horizons? Investment time horizons are time periods applied to the assessment of the potential of an investment in terms of its economic impact. As per my previous blog entry, economic impacts are results or consequences of social and environmental change caused by an investment. Some examples; many people in society now walk around with headphones or ear pieces on, listening to music emanating from a device that has been called an iPod or MP3 player - if we are not being brand specific. The original investment by apple in product development, production and marketing of the iPod has had significant economic consequences for a subset of society that this investment has impacted on. This can be measured by the net overall increase in market value attributable to the companies that are impacted. I say net, because some companies, like Sony, have lost market value even though they have brought out their own MP3 devices. Suppliers of component parts, and retailers like Harvey Norman have gained market value as consumers decide to spend their hard earned money in these retail outlets rather than on clothes, drink or food. Clothing and food outlets have lost for the same reason. However, the net result is probably positive as the device has created a feel good effect that makes people spend money.

If there is a net increase in wealth from the release of the iPod, which I suspect there is, then the increase is societies way of rewarding the innovation. The increase represents societies view of the higher standard of living the device has given them.

Another example is the increase in property values delivered to houses or land that surrounds new infrastructure development. This increase in value is reflecting the greater standard of living provided to those impacted by the investment through faster travel times, better health, safer living etc. This example illustrates the full process of investment decision making. A government makes a decision to build public transport in an area, the affected area now has faster commuter times; be they by car, rail or bus. Housing prices increase due to this higher living standard. More people are attracted to the area because of the higher living standard. The wealth increase is the result of the social change.

However, all of these examples are transient. The iPod will be superseded by some other piece of technology in the future. Alternatively, people may start to suffer hearing loss from playing them too loud or cancer from magnetic radiation. When these events occur, the economic value will erode, and if Apple hasn't innovated with something new, it's market value will deteriorate.

With this in mind, to what time horizon should we be looking to when assessing the potential benefits of the investment? Obviously, this will vary depending on the investment, but typically, the time horizon used in practice is too short. In the iPod example, did Apple assess the risk of being sued for causing deafness or cancer? If this effect is large enough, it could threaten the very existence of the organisation (e.g. tobacco companies and their short term assessment on the effects of lung cancer on their businesses and asbestos companies and their short term assessment of the effect of asbestos on their companies). Eventually, the social consequences will impact the business.

The question is, should these long term consequences be included in the assessment when making the decision to invest? It should be noted here that I am not asserting that iPods will make people deaf or will cause cancer. What I am asserting is that these possibilities should have been reviewed when making the decision to launch the product. If the risks were high, then mitigating steps should be taken immediately, and the overall economic value of the product reduced accordingly.

In the public infrastructure example, over time, the roads will become blocked again, pollution will increase and the value society places on the area impacted will reduce. Should this be taken into consideration when making the decision to invest?

My belief and answer to these questions are yes. Time lines must be lengthened. Even though forecasting the effects will be difficult and the variance of our estimates high, we must start modelling these consequences if we are to make better investment decisions. The long term will always, one day, be the short term. Asbestos companies are now paying for what they once thought was a long term problem. It is now their current problem. If they were to include the negative consequences back when they made the decision, would the decision have been the same?

Sometimes we will not know or be aware of these consequences, but investment decisions are not a buy and hold proposition. Decision makers have the capacity to change their mind at any moment. By constantly re-evaluating the investment decision and by keeping the time horizon long, we should be able to adjust quicker to negative consequences and hence reduce the negativity.

It is my belief that in using this longer term model, economics becomes the sole measure for assessing an investment decision, but the drivers for that assessment, social and environmental change, are being properly incorporated into that assessment.

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