Capitalism needs new glasses
It’s nice of the World Economic Forum to bother. Every January, they release their Global Risks Report, reminding us, yet again, that extreme weather and the failure to mitigate climate change are the biggest long-term risks the global economy faces. Cue headlines — and then… nothing. No matter how many times we receive this particular message, we seem to be incapable of acting on it. Why?
It would be easy to blame human nature. But human nature is full of paradoxes. We are selfish and compassionate. We are prone to what behavioural economists call ‘hyperbolic discounting’, yet we also care deeply about what happens in the long term.
The trouble is not human nature per se: it’s that our current economic and societal operating system amplifies certain of our biases and values, while muting others. Understanding how this process of selective amplification and muting works is crucial if we want to adjust it. To create a system capable of responding to the long-term risks WEF highlights every year, we first need to understand why today’s system is incapable of doing so.
The answer to that question is complicated, but a critical and under-appreciated element of the story is the role played by the theories and models that underpin how modern capitalism allocates its financial (and other) resources. The meta-logic by which today’s capitalism makes decisions can be expressed as follows:
(DCF + MPT) x SVM
Let me explain.
1. DCF: Discounted Cash Flow analysis
Discounted Cash Flow analysis is one of the oldest tools in the book. As soon as humans started investing money — in other words, as soon as capitalism was born — they needed a way of determining what was a good investment and what wasn’t. DCF analysis emerged in 18th century Britain as the solution to this problem.
In simple terms, DCF allows investors to calculate the value of an investment based on its expected future cash flows. As the name suggests, those future cash flows are discounted. This means that future profits (and losses) are given less weight in decisions about how to allocate money than current ones. DCF analysis also ignores social and natural capital and their potential impact on future profits and losses.
Steve Waygood, Chief Responsible Investment Officer at Aviva Investors describes DCF as ‘a super wicked problem with profoundly negative real-world consequences’. His explanation for this:
‘DCF ignores social capital as it is external to the corporate profit and loss statement. DCF ignores future generations with its discount rates. And it assumes away the need to preserve natural capital by assuming all investments can grow infinitely… We are left with millions of professional investors managing trillions of assets on our behalf, all of which largely ignore the one planet boundary condition.’
2. MPT: Modern Portfolio Theory
First introduced 70 years ago, Modern Portfolio Theory underpins how trillions of dollars are managed in today’s world. It has driven the rise of index investing, the pioneers of which — firms like Vanguard and BlackRock — are, today, the biggest beasts in the financial jungle.
The basic idea behind MPT is that investors can deliver optimal returns for a given level of risk by building diversified portfolios. It assumes that risk can be adequately captured by analysing the volatility of a stock’s price. This removes the need for investors to understand a company’s business model or its operating environment: risk is calculated by looking at the performance of the company’s stock price only.
MPT also assumes that investors cannot affect the risk-return profile of the market as a whole. This was a fair assumption back in 1952 when the economist Harry Markowitz first came up with MPT: at the time, the vast majority of shares were owned by individual retail investors, who definitely didn’t wield enough influence to affect the performance of the whole market.
But today, most shares are owned and managed by massive institutions. These institutions are highly exposed to systemic risks that cannot be diversified away. The returns of large institutional investors are determined primarily by the performance of the market as a whole and only marginally influenced by their ability to outperform the market, or generate “alpha”.
Unlike the individuals who dominated financial markets in Markowitz’s day, today’s large institutional investors do have the clout to affect the market’s risk-return profile. But their adherence to MPT holds them back. As one recent report puts it:
‘They have adopted an investing model that rejects the very idea of common sustainability guardrails, which are needed to manage overall market performance, the dominant determinant of an institution’s return on stocks.’
3. SVM: Shareholder Value Maximisation
The norm that maximising shareholder value should be the guiding principle of corporate management began to emerge in the 1970s and went mainstream in the 1980s. It was a response to a genuine problem: too many CEOs and corporate management teams were acting as though they were accountable to nobody. Their empire-building and expense accounts were serving nobody’s best interests except their own. Into the breach stepped SVM.
Milton Friedman famously set out the case for SVM in a 1970 New York Times OpEd called ‘The Social Responsibility Of Business Is to Increase Its Profits’. Shortly after Friedman’s OpEd was published, two business school professors, Michael Jensen and William Meckling, were commissioned to write a paper elaborating on how his ideas should be applied by business leaders. The resulting article, which was published in the Journal of Financial Economics in 1976, quickly became a mainstay of business school reading lists.
Whereas Friedman had left open the possibility that companies should do things that may not produce immediate returns if they were likely to pay off in the long run, Jensen and Meckling were more insistent that SVM meant SVM now. The only meaningful measure of a company’s value, they argued, was its stock price today — and it was management teams’ responsibility to maximise that stock price. Anything that didn’t affect the stock price today wasn’t worth spending time on.
In effect, therefore, SVM made corporate decision making subservient to a financial industry that was already programmed to act myopically because of the assumptions embedded in DCF and MPT.
New lenses
Today’s business leaders and financiers have been trained to use these theories and models and, generally, not to question them. The result is a form of capitalism that is effectively blind to the systemic challenges that threaten our individual and collective prosperity over the long term.
To avert catastrophe, we will have to do things that are impossible to justify using the theories and models of the old order. Businesses will have to make decisions that are unjustifiable under Shareholder Value Maximisation. Investors will have to allocate capital in ways that look crazy when viewed through the lens of Modern Portfolio Theory and Discounted Cash Flow analysis.
Instead we will need new theories and models to guide our decision making. Some of these alternatives already exist — at least in chrysalis form. But, as John Maynard Keynes once wrote, ‘the difficulty lies not so much in developing new ideas as in escaping from old ones.’ We must be willing to look a bit crazy and to let go of old assumptions that no longer serve us well.
Ultimately, the reason WEF’s annual warnings are not heeded is because there is no place for them in the mathematical equations that drive our decision making today. Our old prescription — (DCF + MPT) x SVM — is no longer working for us. It’s time for a trip to the optician.
