Capitalization: The Neglected, Misunderstood Step-Child of Modern Finance

We’ve been pummeled with the importance of saving. The financial community told us it’s best to invest those savings. They’ve never mentioned the alternative use of savings: capitalization. Consequently, we’re cash-strapped, investment-dependent, and control-deprived. There’s a better way.

Thanks to Kaye Lynn Peterson for help editing.

You’ve Heard the Conventional Wisdom

Go to school, work hard, get good grades, graduate, get a job, work hard, save money, invest wisely. Who hasn’t heard some version of that story? In fact, to contest it would sound odd to the modern ear, especially that last part: saving and investing. What else would you do with your hard-earned savings other than invest?

First, we should note that investing is not the only thing you can do with income. There are three options. We all know the first: consumption. Technically speaking, consumption is a purchase of a good or service that will be used for the direct satisfaction of an individual’s given end (goal). You consume food to directly satisfy your hunger. You drink to directly satisfy thirst. You jump out of an airplane with a high-tech bed sheet strapped to your back to directly satisfy your sense of adventure and danger — well, some of us do.

Then there’s investment. Everyone who’s concerned with their finances, either from a personal or commercial perspective, has heard the term somewhere between one hundred and an infinite number of times. However, rarely do financial pundits put forth a specific definition. The names we assign to various transactions differ due to the purpose and perspective of the individual. From the perspective of the investor, the purpose of the transaction is to acquire an asset that will either: increase in value (appreciate) on the expectation of sale for a gain, produce income for the owner (cash-flow), or both. Maybe we don’t operate with that precise definition in mind, but it probably makes sense to most of those who do invest or consider doing so.

Oh, the Possibilities

This does not exhaust the possible uses of income. There’s a third, and it is arguably the most crucial of the three choices in our modern economy. It’s called capitalization.

Obviously, capitalization means “to build capital.” But what exactly is capital? Economists have struggled with the definition of capital for centuries. For the purposes of this article, we don’t need to get too far into the weeds, though it may be helpful to understand the basic source of confusion. Maybe you’ve heard of “capital goods,” like, for example, the machines used in automobile factories to make the actual cars. A capital good, therefore, is a good used to produce other goods. A capital good is also known as a “factor of production.”

But there’s another element to capital. Maybe you’ve heard the term “financial capital.” I particularly like Friedrich A. Hayek’s description of this form of capital in his introduction to Carl Menger’s Principles of Economics. Remarking on one of Menger’s articles, Hayek writes:

It is pretty certain that we owe this article to the fact that Menger did not quite agree with the definition of the term capital which was implied in the first, historical part of [Eugen] Böhm-Bawerk’s Capital and Interest. The discussion is not polemical. Böhm-Bawerk’s book is mentioned only to commend it. But its main aim is clearly to rehabilitate the abstract concept of capital as the money value of the property devoted to acquisitive purposes against the [Adam] Smithian concept of the “produced means of production. (bold added)

Capital goods, or factors of production, are what Hayek refers to as the “Smithian concept of the ‘produced means of production.’” The second, Mengerian concept of capital, what we might call “financial capital,” is what Hayek refers to as “the money value of the property devoted to acquisitive purposes.”

Let’s break that definition down and see how it applies to our modern financial experience.

“Money value of the property…” is pretty simple. This refers to the market value of an asset, i.e. the amount of money for which an asset would sell to a willing and able buyer.

“…devoted to acquisitive purposes” is more complex. Recall above that we use different names to describe transactions based on perspective and purpose. For something to be “devoted to acquisitive purposes” in the economic world, you might say that from the perspective of the owner, the purpose of the (money value of) the asset is to acquire other goods and services (wealth). We can wrap this up with an updated definition of capital as it applies to 21st century finance.

A Powerful Concept of Capital

Capital is the monetary value of assets that is used to acquire wealth. This is distinct from the idea that the capital consists of the asset itself. Under this definition, capital is the theoretical value for which a given asset would sell on the market.

Why do we need this alternative definition of capital?

Notice how distinct capital is from investment. Recall that the purpose of investment is to capture a monetary gain from sale of the asset due to appreciation, to receive cash-flow, or both. Whereas, the purpose of capital is to acquire wealth. You could even say that one potential use of capital is to acquire investments (a form of wealth).

Consider what these conceptual differences between investment and capital mean in practice. An investment — even one that cash flows — may ultimately be liquidated (sold) in order to capture the appreciation (unhelpfully called a “capital gain”). Investments like stocks, real estate, and businesses are generally sold in due time for exactly this reason. In fact, cash-flow itself is often relevant to investors because it can be used to calculate the value of an asset, and hence to establish a benchmark against which future changes in value can be judged in order to determine whether to sell the asset [technically speaking, the present value of an asset is the discounted sum of future cash-flows].

In contrast, if capital is a pool of financial resources (the money value of an asset or assets) the purpose of which is to acquire more wealth, you probably wouldn’t want to sell it. At this point, you may be wondering how in the world someone could use capital in order to acquire wealth without selling the capital. This brings us to the concept of leverage. In order to use capital to acquire wealth without liquidating it, you might borrow against the (capital) value of the asset and use the borrowed funds to make your purchase. In this manner, you might say that one leverages capital in order to indirectly acquire wealth.

Have you heard the phrase “never touch the capital” (or principal)? It’s an old-money concept that gets at exactly what we’re talking about above. In fact, the phrase only makes sense if you treat capital according to the Mengerian approach with which we’ve been working. The way you would “never touch the capital” yet still benefit from it is through leverage. By leveraging (borrowing against the value of) capital in order to acquire wealth, you get the desired wealth without liquidating what you used to acquire it in the first place.

Why not just liquidate capital? Why do wealthy, old-money people place so much emphasis on preserving it?

To fully understand this attitude toward capital, we have to fill in one more piece. The reason you would never want to touch capital, other than because the rich people say it’s the right thing to do, is because of the concept of compounding. I’ve dug into the idea of compounding elsewhere, so it will suffice simply to give a definition here: compounding is an uninterrupted increase in value. You can also think of it as a positive percent change in price year after year (i.e. consecutively).

Compounding is half of the essence of the Matthew Principle:

For whosoever hath, to him shall be given, and he shall have more abundance: but whosoever hath not, from him shall be taken away even that he hath. (Matthew 13:12 KJV)

If you were to graph compounding value, you’d get a non-linear curve. In the image below, note that “exponential” is a synonym for “compounding.”

Compounding — or exponential — curves grow slower in early time periods and faster in later time periods.

Notice that the increases in value are bigger in the later time periods relative to those in the former. This brings us back to one of the main practical, meaningful distinguishing characteristics between capital and investment, that whereas an individual may want to sell an investment, he may not want to sell capital. Why would you spend early periods of time owning capital only to sell it as the value (and therefore your ability to leverage) increased at an increasing rate? Answer: you wouldn’t.

Distinctions Matter

It can be difficult to identify whether a given asset is used for capitalization or for investment. Consider a single-family residence. The value of the house will, on average, rise over time (appreciate). It can be rented out to produce income (cash-flow). The value of the house can often be borrowed against (leveraged). Here’s the conundrum: this single-family residence potentially has all of the characteristics both of an investment and capital. So which is it?

Answer: it depends. Recall that what differentiates investment from capital is primarily the purpose of the asset. Therefore, any asset may be considered an investment or something within which to build capital to the degree that asset serves the purposes of investment and/or capitalization.

However, the point in distinguishing between investment and capital is not so much to go back and identify the best term to apply to a given asset, but rather to formulate a robust financial strategy with precision and intention. We can flesh out some of the implications for financial strategy given our above discussion.

An individual with a relatively long-term view (or what is called low time preference) will tend to want to build capital first and to invest second. He is rewarded for his patience and discipline with the consistent, compounding gains that come with “never touching the principal.” His investments are built upon his financial foundation of capital, so that if they fail, he has the ability to acquire more.

The purpose of this article has been to demonstrate the theoretical and practical legitimacy capitalization. Unfortunately, the financial community treats it as the proverbial, unwanted step-child — that is, as if it didn’t exist. The result is a financial clientele who are un- or under-capitalized, i.e. who lack access to cash, who lack control over financial value, and whose financial future is at the mercy of the market. It is a sad, but understandable reality. We are surrounded by the flawed conventional wisdom that to save means to invest. I hope this article has demonstrated that there is a better way.