The Capital Allocation Spectrum

Every capital allocation decision creates or destroys value — The spectrum runs from wartime waste to world-changing innovation — Civilization’s progress depends on the return each decision earns.

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THE CAPITAL ALLOCATION SPECTRUM

Capital allocation is the enabler, or destroyer, of the world’s progress. When done correctly, capital allocation creates value for everyone. Proper capital allocation moves civilization forward.

Capital allocation decisions are made by everyone, every day. Optimizing these decisions has the potential to create tremendous, world-changing value. Because of capital allocation’s humanity-changing superpower, it is an essential skill for everyone capable of understanding its function.

The Spectrum

The spectrum of capital allocation decisions is wide. The world can be improved by incremental daily decisions, or by focusing on the ends of the spectrum to allocate capital to its highest and best use.

Conversely, poor, or selfish, capital allocation decisions accelerate the entropy that fights against order.

Capital Destruction

War is the most destructive and wasteful use of capital. Investing money in ammunition to destroy a target results in both the destruction of the target and the ammunition itself. In this way, literally nothing is left from the capital invested.

Similarly destructive, given its prevalence, is corruption. When bribes are required for business to get done, this friction weighs on investment returns. When a government pays $640 for a toilet seat cover, substantial funds are wasted.¹ Compared to war, at least the toilet seat cover is eventually installed and used. Ultimately, though, the return on capital spent is poor.

Notably, war-torn and highly corrupt countries see low or declining standards of living. This is the exact outcome one would expect when resources are “invested” at negative returns.

The Middle

Most capital allocation decisions land in the middle of the spectrum, generally neutral. A piece of equipment adds capacity but requires so much maintenance that costs offset the benefit. A management team pays fair value in an M&A transaction and creates nothing.

The “zero-sum” interpretation of financial markets focuses on this middle. Every public market transaction transfers value from buyer to seller. No individual trade creates value.

But functioning markets create value through the incentives they set. Poor capital allocators receive low valuations, occasionally prompting changes in strategy or management.²

Earning a Return

Productive use of capital drives the world forward. In these situations, capital is invested and earns a return. Equipment that improves efficiency, R&D investments that create new products, and facility expansions that produce more product; each of these investments makes the world incrementally better. 

These small but productive decisions improve the world, fighting against natural entropy and decay. A dollar invested at a productive return funds the next piece of equipment, the next research project, the next expansion.

The process repeats across millions of businesses, every year. No single decision changes the world, but in aggregate these choices add up. Returns on ordinary projects quietly compound, over decades, to raise the standard of living of the world.

The Lollapalooza Effect

At the far end of the spectrum sits true innovation. Individuals use their creativity and genius to introduce a new product or revolutionize an industry. Charlie Munger’s “lollapalooza effect” occurs when these ideas combine with capital, scaling an invention to world-changing proportions.³

We are watching a lollapalooza unfold with AI. A revolutionary leap in machine learning, combined with massively scaled computing power, will change the world. Like fire, steam engines, assembly lines, and the Internet, AI will radically change our way of life.

Civilization’s Return

The spectrum is wide, but the math is the same at every point. Capital invested at a return moves the world forward. Capital invested at a loss drags it back.

Civilization’s progress depends on every individual decision and the return it creates. There is no higher and better use of brain power than improving capital allocation decisions across the globe.

Notes:

1. Biddle, Wayne. “Price of Toilet Seat Is Cut for Navy.” The New York Times, February 6, 1985. NYT 

2. See Reference Equity’s proposal to CBIZ to return to value-creating M&A

3. Munger, Charlie. “The Psychology of Human Misjudgment.” Speech at Harvard University, June 1995. Revised 2005. Farnam Street