Tuesday, 4 February 2014

Making Money Does Not Necessarily Mean Creating Value

A lot of emphasis is placed on making money nowadays. No problems with that. However some people don't really care about how they make money. As long as they are able to generate an income or profit, it doesn't matter whether they create value in the process.

Value is created when you produce an 'economic or social good' or provide an 'economic or social service' that is of benefit to people or society. If you get rich doing this, good for you and society.

However, there are also many ways of making money by wealth reallocation or worse, value destruction, rather than value creation.

Take for example gold trading or gold investing. If you purchase a gold bar and in one year the price appreciates 30%, you'll make money from that investment when you sell the bar. However nothing really gets created. The gold bar is still the same gold bar. No value created but you made money.

We can also take a look at derivative investments. It's really a zero sum game, i.e. the net gain or loss from all investments in the instrument would amount to zero. Meaning that if you made money, it has to be at the expense of somebody else. A small portion will go to the broker and the exchange. 

Nothing is created. Some would argue that you are creating liquidity. This argument may have some merit for commodities but not for many other derivatives. In truth, they are mainly speculative instruments created under the guise of allowing investors to execute so called 'strategies'. The net effect is that derivative exchanges are merely places where wealth is transferred without any real economic good or service being produced.

Not all investments are like that of course. You buy a house and you rent it out, you make money and you create value because you put a roof over someone's head. You buy equity in public listed companies (not all), they create value via their products and services, and by employing people.

But not all companies create value. You'll be amazed that some of the companies that create the most 'shareholder wealth', i.e. the biggest profits for the shareholders, actually destroy economic or social value. In my opinion, owning these companies is worse than making money from pure wealth reallocation. At least there is no harm involved in the latter.

You may ask which companies am I talking about? There's no need to name them but just think of businesses that manufacture products detrimental to health. You know them. They are not on the Shariah compliant list and will never be. Unfortunately, people don't really care about these things, as long as they are making money. It's just the way it is. 

In fact, the value creation criteria is one of the factors that can save you from a get rich quick scheme. If somebody suggests that you to invest in a certain scheme, just ask them what is actually being manufactured or what service is being provided.  Most of the time, the person will be hard pressed to give a proper and straight forward explanation.

In some schemes, there may be an underlying activity that creates value, but the profits they claim to generate will far exceed the normal gains derived from that activity by other companies or businesses.

There is also another category of business where money is made out of thin air, i.e. rent seeking.  This occurs when an individual or company gets a contract to do something in which it has absolutely no expertise, and subcontracts the work without contributing anything to the project. 

Of course, this is rather well-known and already condemned by certain quarters, even if technically legal, as there is an element of impropriety in it.  However the first two activities I mentioned above are perfectly legal and acceptable to many.

I feel compelled to write this article as there are now many books and advertisements enticing and convincing people that they can make money and become millionaires by taking part in activities or investing in instruments where money is made off other people rather than via value creation.

Personally, I have more respect for the road sweeper who provides an economic service than someone who becomes a millionaire from a pursuit that generates money purely from wealth reallocation or value destroying activities. Unfortunately, many people do not share this view.

Note: Photo from forbes.com

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