Interest and Risk

As I discussed in previous posts (here and here) when someone provides means of production (capital) to someone else, they are foregoing any current benefit they could obtain from that capital (whether actual capital goods as was the plane in the original example or money as a stand-in for such goods).  If they are not compensated for that loss of use then, generally speaking, they will not make the goods available.  If John merely got the plane back at the end of a year, even if the plane was in perfect condition (George had made sure that any damage was perfectly repaired), he’s lost what he could have made from using the plane himself to improve his carpentry.  Likewise, if I loan somebody fifty bucks, I could have used it myself to have a really nice dinner at a restaurant tonight instead.  That same dinner six weeks from now is less valuable to me.  The difference between the value of having something now (present value) vs. having it at some future date (future value) is the interest.

However, all of the above assumes that the loan will be repaid, that there’s no risk.  Risk, however, is a very important part of actual calculations on such things.  Suppose, for instance that the difference between present value and value is five percent.  That is, someone would be indifferent as to whether they received $100 today or $105 one year from today.  But suppose that one time in ten when someone forwent the $100 today they would receive nothing in a year instead.  Nine times out of ten, it would be fine, but that tenth…

In that case, the person who was indifferent to $100 today vs. the certainty $105 in a year is going to be a lot more hesitant to make that deal.  Only by “sweetening” the deal would the person be willing to make it.  So on an average of ten such deals, the person making the loans would spend $1000 and would want to get at least $1050 back from it.  But one of those ten won’t pay pack (on average).  To get that $1050 back, he has to get it from the other nine deals, or $116.67 for each of them.  One person in ten not paying back the loan costs everyone else $11.67.

This, simply, is why some loans, even in the same economy, charge higher interest rates than others.  The person loaning at the “usurious” rate of 16.67% isn’t cheating.  It’s simply necessary to charge that much to cover the costs of defaults while still paying enough for the loan to happen at all.  The lender is only making 5%. The rest covers defaults.

When certain politicians complain about the high interest rates of student loans compared to mortgages they are ignoring the concept of risk.  Mortgages are generally offered where the lender is financially stable and even if the borrower defaults, the lender isn’t completely out because the building and land retain some value which the lender can use to get some return.  When it comes to student loans, half of students who enter college drop out within six years.  Then there’s the question of whether the student, even if they do graduate, will obtain a job that pays sufficient to pay off the loan.  The risk Of course government has long been involved in those loans, first with federal guarantees (assuring the lender that they would be paid something even if the student defaults) then taking over the program entirely.

The concept of risk is one of the reasons why stocks tend to pay higher returns than bonds.  Bonds are loans.  They have a set term and a set amount.  If the company goes bankrupt (as most do–2/3 of new businesses failing within the first 10 years and even large and well established companies can end in bankruptcy) the bond owner can generally get something, even if it’s pennies on the dollar, as they are creditors to be paid out of the liquidation of the businesses assets.  Stock holders, however, can end up with nothing but the paper their certificates are printed on.  Only the promise of greater returns from those companies that do succeed induces them to invest at all.

Look up above at how much extra has to be charged on a five percent loan to cover a default rate of even one in ten.  Now look at new business failures.  Two thirds within ten years.  The same source reports thirty percent failing within two years and fifty percent within five.  Let’s look at that in numbers.  That investment of $100, over two years would mean it would have to return $110.25 to make five percent annually.  One hundred such investments, then would have to return $11025.00 to be “worth it” (again presuming 5% per annum represents the difference between future and present value).  If thirty percent of the businesses fail (thirty out of one hundred) the remaining 70 have to return that entire $11025.00 between them or $157.60 each on that $100 investment.  That works out to a 25.6% annual rate of return average among the surviving businesses.  Twenty point six percent simply covers the risk, the loss due to the businesses that fail, so that the investor can get an overall five percent rate of return on his total investment.  Risk.

When people complain about the “unfairness” of returns people get from highly successful investments they are looking only at the successful investments in hindsight.  People generally did not know in advance which investments were going to be successful.  When Ronald Wayne sold his 10% share in Apple for $800 after a mere twelve days, he was not acting irrationally.  It was an entirely rational decision given what he knew at the time.  In Sam Walton’s early days few, if any people realized what an international giant his modest chain of stores would become.

Those complaining about people getting large returns from investments are not seeing that those people are both willing and able to manage the risk inherent in the process.  There are a number of reasons why those people might be able to do so.  They may have accumulated (by forgoing immediate benefit in favor of future benefit) sufficient resources either individually or by aggregating from many others (mutual funds are an example of this) so as to be able to invest widely thus spreading the risk so that successes outweigh failures.  They may be able to judge individual risks more closely so that more of the entities in which they invest succeed and fewer fail than the average.  In both cases, resources are made available to produce goods and services to the betterment of the economy as a whole, resources that would not be made available if the returns were insufficient to cover the cost of risk.

Ignoring risk, and the ability and willingness to manage it, is behind most, if not all, criticisms of the “unfairness” of capitalism.  In the words of John Paul Jones (not that expression, his other one): “He who will not risk, cannot win.”

You just have to do it intelligently, and make sure the reward is worth the risk.

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