McKinsey: Is there Bias against Investment?

Econintersect:  McKinsey Quarterly reports that the McKinsey Global Survey has found that most executives believe their companies are not making sufficient investment, particularly for expensed items.  More than half cited sales, marketing, new products and new market development as areas needing more investment.  About 2/3 of the executives said there was too little investment in product development.  McKinsey says that not only are companies missing growth opportunities, they are also damaging the overall economy as job creation is lost.McKinsey finds that a common problem with the executives surveyed is loss aversion. From the quarterly report:

These executives also display a remarkable degree of loss aversion—they weight potential losses significantly more than equivalent gains. The clear implication is that even amid market volatility and uncertainty, managers are right now probably foregoing worthy opportunities, many of which are in-house.

Emphasis on loss aversion is a logical response to an expectation for deflation.  In a deflationary environment a dollar is worth more in the future than it is today.  Thus wealth (purchasing power) grows over time and averting loss is gaining wealth.

The following graphic from McKinsey summarizes the findings:

Other areas of the survey find that reduced investment has hurt company returns.  In business, as in human relationships, one might say that “faint hearts never win fair ladies.”

McKinsey Quarterly summarizes as follows:

Executives may be limiting the investments of their companies because of economic fundamentals and policy uncertainties. But their decision making is also tainted by biases and loss aversion that harm performance and cause companies to miss potentially value-creating opportunities.

The data on private investment in the following graph from the St. Louis Fed shows that the last twenty years has data that makes the last five years look like the deflation of a bubble that grew over the period 1991-2006.

POP is the total population of the U.S.

The strong relationship between private investment and stock market returns is seen in the following graph:

Hidden in the above graph is a dramatic story.

Chapter one of the story is shown in the following graph, where the data history has been extended back to 1957:

The ratio of S&P 500 value to gross private investment was normalized to first quarter 1957 = 1.0.

Chapter two is shown in the following graph:

When the return to stocks was lower for private investment, the growth of personal income was 50% higher.  When we look specifically at compensation paid to employees it is seen that the improved return to employees per unit of investment continued until about 1990.  The following two decades showed employee compensation had no further growth relative to private investment.

COE is Compensation of eEmployees, paid.

Chapter three shows the systematic decline in employment growth per unit of investment over the entire 50-year period covered, even as real investment generally grew.

PAYEMS is the total non-farms payroll.

The effect seen in the previous graph is related to productivity improvement.

From 1948 to 1991 the average annual productivity gain was just under 1%.  For the most recent 20 years the average is over 2% per year.

One final graph shows how the pendulum has swung from labor to capital is the following graph which shows how the ratio of compensation to employees to the value of stocks rose until 1980 and has declined since.

Taken all together the data shows a shift in the return on investment away from labor and to improved return on capital over the past three decades.  The findings of the McKinsey survey indicate executives may have doubts about whether the twenty-year improvement for return on capital may be over or not.  Certainly the fact that the current level of productivity improvement is below the pre-1991 average is not going to help change that.

Another sad part of all this is that the lower level of productivity improvement does not appear to be producing an improved situation for labor either.  Right now there are no winners.

Sources:  McKinsey Quarterly and GEI Analysis