Excess returns by chance or design?

[Shann Turnbull <sturnbull@mba1963.hbs.edu>]

Dear Homestead group

Michael Harington wrote

"one can actually get an excess return by chance. But if it becomes clear
that more than chance is involved, arbitrage will drive the risk-adjusted
rate of return down to the mean."

However, it has not been clear to generations of economists that excess
returns are inherent in the current rules of property ownership which
allows the capture of profits in excess of the incentive to bring forth the
investment.  Arbitrage cannot correct excessive returns when market forces
cannot overrule the static, monopoly, unlimited life rules for owning
property.  The capture of excessive returns can be what I describe as
"surplus profits".   However, these are not measured by accountants and so
not noticed by economists as described in my postings in the economics of
ownership discussion group.  It is the capture of profits in excess of the
incentive to bring forth investment that contributes to the inequality of
wealth and so the cause of the problem which COG is seeking to correct.
The solution is to replace the static, monopoly, unlimited life rules of
ownership with dynamic, inclusive, limited life rules.

Without insight into how the problem of wealth concentration arises, we do
not have a basis for evaluating which solutions to the problem will be most
efficacious.  If  the statement made by Michael quoted above represents
orthodox economic assumptions it indicates why economists cannot understand
the problem of how the rich get richer.   

Because accountants do not distinguish between profits and surplus profits,
the theories of finance quoted by Michael have limited relevance to
identifying surplus profits.  Theories of finance may identify what
economists may call "excess profits" but these may not be related to
surplus profits.  Surplus (cashflow) profits can arise with accounting
losses and excessive accounting profits can arise without any surplus
profits.  In short, economic theories have little relevance to identifying
or understanding the problem of wealth concentration.   The problem is
accounting profits are confined to accounting periods whereas investors and
business analysts consider profits over the operating life of the
investment. or their investment time horizon. which ever is the shorter.

Michael is concerned about the relationship between risk and excessive
returns, but from the perspective/paradigm of a business person, there may
be no relationship between risk and obtaining excessive profits in the form
of surplus profits.  Economic theories based on accounting concepts of
profits may have little relevance to real world investing.  This is why
business people base their analysis on cashflows rather than profits as
explained in my "New Strategies for Structuring Society from a Cashflow
Paradigm" article in the COG library.
http://cog.kent.edu/lib/turnbull1/turnbull1.html
 
The "misinterpretations of what the role of risk plays" which concern
Michael arises in part because economists describe "excess profits" in a
way which is quite different from what I define to be surplus profits.

Regards

Shann

At 11:20 AM 12/1/2000 , Michael Harrington wrote:
>Dear Homestead Group,
>
>There seems to be a lot of understandable misinterpretations of what role
>risk plays in human behavior and how that applies to the issue of employee
>ownership. Humans are risk averse, this applies to capitalists and workers
>alike. The theory of finance has adequately proven that return is positively
>related to risk, so as risk goes up so does the expected return AND
>vice-versa. This means that at the margin, assuming more risk demands more
>return AND demanding more return assumes more risk. These are a priori
>principles, which means the actual outcome may be different - one can
>actually get an excess return by chance. But if it becomes clear that more
>than chance is involved, arbitrage will drive the risk-adjusted rate of
>return down to the mean. This relationship can be shown conclusively by
>empirical evidence as well as theory. So, if workers want a bigger piece of
>the pie they will have to assume more business risk or at least devise an
>ownership mechanism where they can get paid for the risks they're already
>taking. This is not as onerous as it sounds as overall risk could be reduced
>with efficient risk management or insurance pooling. This is the essential
>difference between ownership and employment.
>
>What does this mean for employee ownership? On any one particular deal,
>perhaps nothing. But in general it means that all parties - owners,
>creditors and employees - are acutely aware of the risks they are assuming
>and if they are getting paid for assuming them. As Dave Wheatcroft argues
>below, awareness of risks may be partly a function of education and
>acculturation as some people learn that judicious risk-taking actually
>increases overall security. But considerable research in evolutionary
>psychology suggests that humans are intuitively very astute in understanding
>threats to survival - much more astute than in trying to calculate utility
>or profit maximization - but this, as nature has determined, is a short-term
>perception. People also vary in risk preferences according to their frames
>of reference. This means that people are sometimes more risk averse than at
>other times or than other people, depending on their endowment positions and
>their perceptions of an uncertain environment. This explains Dave's point
>below about risk preferences. Risky gambles have 2 dimensions - how much you
>gamble from your wealth and how risky the gamble is in terms of variance of
>returns. People without disposable income take very risky gambles with very
>low stakes - i.e. lottery tickets and the horses, trying to hit the big one.
>But rich people interested in preserving their capital take low risk gambles
>with high stakes and end up safely making more money than they can spend.
>(Barriers to entry in investment markets also present the perverse outcome
>that those with lots of money get access to better returns at lower risks
>than the market at large - venture capital partners, for instance) Both of
>these strategies favor survival but we can easily see the better strategy
>for the long haul. 
>
>The point for employee ownership is that ESOP dealmakers should be sensitive
>to the risk perceptions of all participants involved - business owners, bank
>lenders, employees AND outside shareholders: 
>
>--If lenders are not confidant of the valuation of the employee-owned firm
>relative to the previous capitalist-owned firm, they will demand that
>someone else - the business seller or the employees -- assume this risk.
>This breaks the deal in many cases as business owners are trying to divest
>this risk at fair market value. 
>       
>--Employees should also be reticent to assume risk that they cannot insure
>or diversify away. 
>--Outside shareholders' concerns about control over their paid-in capital
>will withdraw or refuse to provide it. 
>
>Policy measures can strongly effect the risk-return ratio on the margin -
>the tax break for ESOPs does this and other tax measures that reward equity
>investments like dividends and cap gains would do this as well. The pooling
>of creditor loans for employee buyouts in a secondary market may also mean
>all the difference for the lack of information about post-buyout valuations,
>though this may sound a bit farfetched at the moment. 
>
>In general, financial markets manage risk and they were created because
>suppliers and users of capital demand it in order to do business. And it
>seems to work out very well given the wealth created (but not yet adequately
>distributed...)
>
>
>Michael Harrington
>The Milken Institute
>1250 Fourth Street
>Santa Monica, CA 90401
>mharrington@milken-inst.org
>TEL: (310) 998-2699
>FAX: (310) 998-2625
> 
>
>
>
>
>-----Original Message-----
>From: Deborah Groban Olson [mailto:dgo@esoplaw.com]
>Sent: Monday, January 10, 2000 9:27 AM
>To: Homestead
>Subject: Fwd: BOUNCE homestead@cog.kent.edu: Non-member submission from
>["Dave Wheatcroft" <dwheatcroft@lineone.net>] 
>
>
>>>From dbell@kent.edu  Mon Jan 10 11:31:46 2000
>>X-Sender: dbell@pop.kent.edu
>>X-Mailer: QUALCOMM Windows Eudora Light Version 3.0.6 (32)
>>Date: Mon, 10 Jan 2000 11:30:57 -0500
>>To: dgo@esoplaw.com
>>From: Dan Bell <dbell@kent.edu>
>>Subject: BOUNCE homestead@cog.kent.edu:    Non-member submission from
>>  ["Dave Wheatcroft" <dwheatcroft@lineone.net>]   
>>
>>Deb,
>>
>>This message from Dave Wheatcroft did not get relayed
>>becaused he is not subscribed to the homestead list.
>>
>>Dan
>>
>>>From: owner-homestead@cog.kent.edu
>>>Date: Sat, 8 Jan 2000 13:44:25 -0500
>>>X-Authentication-Warning: cog.kent.edu: majordomo set sender to
>>owner-homestead@cog.kent.edu using -f
>>>To: owner-homestead@cog.kent.edu
>>>Subject: BOUNCE homestead@cog.kent.edu:    Non-member submission from
>>["Dave Wheatcroft" <dwheatcroft@lineone.net>]   
>>>
>>>>From cogowners@cog.kent.edu  Sat Jan  8 13:44:25 2000
>>>Received: from shaggy.lineone.net (shaggy-s1.lineone.net [194.75.152.225])
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>>>Message-ID: <001901bf5a07$8ea1c2e0$ad1c063e@default>
>>>From: "Dave Wheatcroft" <dwheatcroft@lineone.net>
>>>To: "Homestead COG" <Homestead@cog.kent.edu>
>>>Subject: Comments to Deb 5.1.2000
>>>Date: Sat, 8 Jan 2000 18:36:13 -0000
>>>MIME-Version: 1.0
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>>>Dear Homesteaders
>>>On the risk factor can I just make the following comments.
>>>As a worker the things that dominates how you spend your money depends =
>>>on disposable income.
>>>I don't take the view that workers don't invest in ownership (Shares) =
>>>because of the risk factor. More likely there are other forms of =
>>>competition for the money that are more attractive to the worker, =
>>>betting on the horses and the lottery to name just two of the most =
>>>popular but far more risky, the reason for this, in the UK at least is =
>>>the fact that the workers were not brought up in a shareholder =
>>>environment and they don't understand it, they are far more familiar =
>>>with  betting as it is straightforward and easily accessible to them =
>>>even though it is almost certain they will lose their money.
>>>So this is the challenge for us, how do we convince them that "Betting" =
>>>on shares particularly in the company where they work is better?
>>>The answer is publicity, education and accessibility.
>>>For one thing it can be as secure as banks, take the record and returns =
>>>of the share markets over the past few decades.=20
>>>For another it can just as exiting as horses (although a little slower =
>>>tracing the movement of your shares every day or hour if you are that =
>>>keen.
>>>Finally if you pick the right investment you can be on a real winner, =
>>>which is especially rewarding if you are involved and have contributed =
>>>to it yourself.
>>>These are the points we are not getting across to the workers.
>>>I read in a book once that the test of how good a company thinks it is  =
>>>to offer some of it's shares to the workers to buy and watch the take =
>>>up.
>>>If the workings of the company is transparent the workers would be more =
>>>likely to invest in it, it's the secrecy of the Board Room that puts =
>>>workers off and the feeling that they are just a number and not a valued =
>>>person, even if that converts to a valued asset.
>>>
>>>Spreading the ownership and sharing the wealth, even in some small way, =
>>>can only be good for the company, community, nation and world. =
>>>unfortunately in the past few decades things have been moving the other =
>>>way and although EO has slowed it down a little there is still a =
>>>mountain to climb to even stop the trend let alone reverse it, but that =
>>>shouldn't stop us from keeping on trying
>>>  =20
>>>
>>>Dave Wheatcroft
>>>01246 233438 -Tel
>>>
>>>------=_NextPart_000_0016_01BF5A07.3DF68420
>>>Content-Type: text/html;
>>>     charset="iso-8859-1"
>>>Content-Transfer-Encoding: quoted-printable
>>>
>>><!DOCTYPE HTML PUBLIC "-//W3C//DTD HTML 4.0 Transitional//EN">
>>> >>>http-equiv=3DContent-Type> >> >> >> >> >>
>Dear Homesteaders
>>>
>On the risk factor can I just make the following = >> >>comments.
>>>
>As a worker the things that dominates how you = >>spend your=20 >>money
>depends on disposable income.
>>>
>I don't take the view that workers don't invest = >>in=20 >>ownership
>(Shares) because of the risk factor. More likely there are = >>other
>forms=20 >>of competition for the money that are more attractive to the
>worker, = >>betting on=20 >>the horses and the lottery to name just two of
>the most popular but far = >>more=20 >>risky, the reason for this, in the
>UK at least is the fact that the = >>workers were=20 >>not brought up in a
>shareholder environment and they don't understand = >>it, they=20 >>are far
>more familiar with betting as it is straightforward and easily=20
>>>accessible to them even though it is almost certain they will lose their
>= >> >>money.
>>>
>So this is the challenge for us, how do we = >>convince them=20 >>that
>"Betting" on shares particularly in the company where they work is=20
>>>better?
>>>
>The answer is publicity, education and=20 >>accessibility.
>>>
>For one thing it can be as secure as banks, = >>take the=20 >>record and
>returns of the share markets over the past few decades.=20 >>
>>>
>For another it can just as exiting as horses = >>(although a=20 >>little
>slower tracing the movement of your shares every day or hour if = >>you
>are=20 >>that keen.
>>>
>Finally if you pick the right investment you can = >>be on a=20 >>real
>winner, which is especially rewarding if you are involved and have=20
>>>contributed to it yourself.
>>>
>These are the points we are not getting across = >>to the=20 >>workers.
>>>
>I read in a book once that the test of how good = >>a company=20 >>thinks
>it is to offer some of it's shares to the workers to buy = >>and watch=20
>>>the take up.
>>>
>If the workings of the company is transparent = >>the workers=20 >>would be
>more likely to invest in it, it's the secrecy of the Board Room = >>that=20
>>>puts workers off and the feeling that they are just a number and not a =
>>>valued=20 >>person, even if that converts to a valued asset.
>>>
> 
>>>
>Spreading the ownership and sharing the wealth, = >>even in=20 >>some small
>way, can only be good for the company, community, nation and = >>world.=20
>>>unfortunately in the past few decades things have been moving the other =
>>>way and=20 >>although EO has slowed it down a little there is still a
>mountain to = >>climb to=20 >>even stop the trend let alone reverse it, but
>that shouldn't stop us=20 >>from keeping on trying
>>>
>   
>>>
> 
>>>
>Dave Wheatcroft
>01246 233438=20 >>-Tel
>
>>>
>>>------=_NextPart_000_0016_01BF5A07.3DF68420--
>>>
>>>
>>--
>>Dan Bell
>>International Program Coordinator
>>Ohio Employee Ownership Center
>>Kent State University
>>Kent, OH 44242
>>(330) 672-3028
>>(330) 672-4063 fax
>>dbell@kent.edu
>>http://www.kent.edu/oeoc/
>>

Shann Turnbull
P.O. Box 266 Woollahra, Sydney, Australia, 1350
Phone: 02 9328 7466 office; 02 9327 8487 home
Fax: 02 9327 1497 home & office.  Mobile 0418 222 378
Outside Australia, replace first "0" with "61" after international access code
Life long E-mail: sturnbull@mba1963.hbs.edu
Alternate:sturnbull@optusnet.com.au
http://members.optusnet.com.au/~sturnbull/index.html