§7. Securities Classified as to Risk

When risk thus operates to lower the rate of interest on safe investments and to raise the rate on unsafe investments, there immediately arises a tendency to differentiate two classes of securities and two classes of investors—precarious securities and adventurous investors on the one hand, and safe securities and conservative investors on the other. Some risk is inevitable in every business, but is regarded by most people as a burden; hence the few who are able and willing to assume this burden tend Edition: current; Page: [219] to become a separate class. When enterprises came to be organized in corporate form, this classification of investors was recognized by dividing the securities into stocks and bonds, the stockholder being the person who assumes the risk and, theoretically at least, guaranteeing that the bondholder shall be free of all risk. Which person shall fall into the class of risk-takers and which not is determined by their relative coefficients of caution,79 as well as by the relative degree of risk which an enterprise would involve for the various individuals concerned. The same enterprise may be perilous for one and comparatively safe for another because of superior knowledge on the part of the latter, and the same degree of risk may repel one individual more than another, owing to differences in temperament or, most important of all, to differences in amount of available capital.80

This shifting of risk from those on whom it bears heavily to those who can more easily assume it discloses another motive for borrowing and lending besides those which were discussed in a previous chapter. Borrowing or lending in corporate finance usually indicates not simply a difference in time shape as between two income streams, but also a difference of risk. The object of lending which was emphasized in earlier chapters, before the risk element was introduced into the discussion, was to alter the time shape of the income stream, the borrower desiring to increase his present income and decrease his future, and the lender desiring, on the contrary, to decrease his present income and add to his future. But the ordinary stockholder and bondholder do not differ in this way so much as they do in respect to risk. They are both Edition: current; Page: [220] investors, and the positions, in which they stand as to the effect of their investment on the time shape of their income, are really very similar. But the stockholder has a risk attached to his income stream from which the bondholder seeks to be free. It is this difference in risk which is the primary reason for the distinction between stockholders and bondholders. The bondholder gives up his chance of a high income for the assurance, or imagined assurance, of a steady income. The stockholder gives up assurance for the chance of bigger gains.

The existence of this risk, tending as we have seen to raise the rate of interest on unsafe loans and lower that on safe loans, has, as its effect, the lowering of the price of stocks and the raising of the price of bonds from what would have been their respective prices had the risk in question been absent.

In the last few years, however, this disparity has been decreased from both ends. The public have come to believe that they have paid too dearly for the supposed safety of bonds and that stocks have been too cheap. Studies of various writers, especially Edgar Smith81 and Kenneth Van Strum82 have shown that in the long run stocks yield more than bonds. Economists have pointed out that the safety of bonds is largely illusory83 since every bondholder runs the risk of a fall in the purchasing power of money and this risk does not attach to the same degree to common stock, while the risks that do attach to them may be reduced, or insured against, by diversification. Edition: current; Page: [221] The principle of insurance84 of any kind is by pooling those risks virtually to reduce them. This raises the value of the aggregate capital subject in detail to these risks.

It is in this way that investment trusts and investment counsel tend to diminish the risk to the common stock investor. This new movement has created a new demand for such stocks and raised their prices; at the same time it has tended to decrease the demand for, and to lower the price of, bonds.

Again, speculation in grain, for example by setting aside a certain class of persons to assume the risks of trade, has the effect of reducing these risks by putting them in the hands of those who have most knowledge, for, as we have seen, risk varies inversely with knowledge. In this way, the whole plane of business is put more nearly on a uniform basis so far as the rate of interest is concerned.

Risk is especially conspicuous in the financing of new inventions or discoveries where past experience is a poor guide. When new inventions are made, uncertainty is introduced, speculation follows, and then comes great wealth or great ruin according to the success or failure of the ventures. The history of gold and silver discoveries, of the invention of rubber, of steel, and of electrical appliances is filled with tales of wrecked fortunes, by the side of which stand the stories of the fortunes of those few who drew the lucky cards, and who are among today's multi-millionaires.

The rates of interest are always based upon expectation, however little this hope may later be justified by realization. Man makes his guess of the future and stakes Edition: current; Page: [222] his action upon it. In his guess he discounts everything he can foresee or estimate, even future inventions and their effects. In an estimate which I saw in print of the value of a copper mine, allowance was made for future inventions which might reasonably be expected. In the same way, too, the buyer of machinery allows not simply for its depreciation through physical wear, but for its obsolescence. New investments in steam railroads are today made with due regard to the possibility that the road may, within a few years, be run by electricity, or that it will be injured by competition of bus lines or helped by terminal connections with them.

It may easily happen that, in a country consisting of overly sanguine persons, or during a boom period when business men are overhopeful, the rate of interest will be out of line with what actual events, as later developed, would justify. It seems likely that, in ordinary communities, realization justifies the average expectation. But in an individual case this is not always true; otherwise there would be no such thing as risk. Risk is synonymous with uncertainty—lack of knowledge. Our present behavior can only be affected by the expected future,—not the future as it will turn out but the future as it appears to us beforehand through the veil of the unknown.