Savings arise when one produces more than he wishes to consume. Savings are the prerequisite to civilization. If all production was consumed within the same day, there would be nothing left over to work with the next day. The individual who consumes everything he produces in a day has no ability to complete tasks that require more than a day’s effort. Savings allow for the ability for one to consume while attaining harder to obtain goals. If the creation of a net for fishing requires three days of work, there must be three days worth of savings for one to live off while creating the net.
The creation of capital goods allows for the efficient employment of means to achieve goals that may not otherwise be possible. By choosing to forgo consumption in the present, one can consume more in the future. However, that is only possible when means are employed properly. If one chooses to work for three days on a net for fishing, and then the net turns out to be useless, he may have simply been better off consuming his resources rather than employing them in ultimately fruitless production. Returns do not autonomously accumulate to capital. Resources that are invested may also be squandered if used in the wrong processes.
Investment is defined as the commitment of resources into something that is expected to gain value. In the financial sense, investing is an act that one undertakes by deferring consumption on present resources and instead employing them in what are perceived to be value-additive activities. A simple form of investing involves saving money to buy a commodity, and then selling the commodity later on at a higher price when it is in higher demand.
Investments are characterized by uncertainty rather than risk. Risk refers to a situation in which the possible outcomes are known and meaningful probabilities can be assigned to them. Uncertainty exists when the future alternatives, their probabilities, or both cannot be known in this manner. Investing therefore does not require a mechanistic determination of expected value based upon known probabilities, but requires one to exercise judgment in the allocation of resources to where they may be the most fruitful.
An investor possesses resources today but seeks to employ them toward an outcome that will occur in the future. However, outcomes in the future are not predetermined events that are waiting to be revealed. Outcomes depend on their causal factors and may differ from expectations by a considerable margin. An investor may correctly understand the resources available to him and still make an erroneous judgment about how those resources should be used. He may construct a home that consumers ultimately do not value, purchase an asset whose price subsequently falls, or devote years of labor to a production process that becomes obsolete.
Investment therefore involves more than just deferred consumption. It involves economic calculation and judgment concerning the future. The key issue is determining where those resources should be directed. Financial markets developed as a method of addressing this problem. Financial markets have developed more varied ways to invest that have been made available to savers. Without financial markets, any proposed endeavor would require one to save and accumulate an astronomical amount of resources to put forth the means towards a particular goal.
A financial market allows the resources of many savers to be combined and used in projects they are often not directly involved in. Instead of an individual having to save enough resources to independently construct an entire enterprise, he can invest his savings with another party that will compensate him accordingly or grant him a residual claim on earnings. The financial system thus creates a division of labor between those who have savings and those who seek to employ savings as means in projects.
A prospective entrepreneur may have ideas and accurate foresight regarding plans to produce a highly-valued item, but with very little savings insufficient to complete the production process. Seeking investment from savers allows him to garner enough means provided he compensates the savers sufficiently for them to entrust him with their wealth. Financial markets allow these two groups to interact. This is far more efficient than self-finance. With only self-finance, the person who discovers an investment opportunity must accumulate enough resources himself to pursue it. Financial markets expand the possible scale and variety of investment by permitting savings to be pooled and allocated.
However, financial markets do not eliminate uncertainty. The investor who purchases a financial asset must still exercise discretion with how he wishes to use his resources. The entrepreneur must also still allocate present resources towards an uncertain future. The existence of financial markets enables voluntary, mutually-beneficial exchanges that allow for resources to be directed to their highest valued ends. People act against uncertainty to try to substitute less-favorable conditions for more-favorable conditions. The growth of a functioning and free society is dependent upon these allocative processes being free of intervention, fraud, and other behavior that prevents wealth creation.
