RISK/RETURN TRADEOFF AMONG FOREST AND NONFOREST INVESTMENTS

WALTER LAIN MILLS, Purdue University

Abstract

Due to forest investment's traditionally low rate of return, investment in forestry has been difficult to explain in terms of standard investment selection criteria such as internal rate of return and net present value. However, there are thousands of forest investors revealing a preference for forest investments. Unless these investors are illogical and irrational, there must be an economic rationale for their behavior. In an attempt to develop an explanation for this revealed investor behavior, risk is added to the investor's selection criteria when choosing among alternative investments. A methodology is presented to measure the physical and financial risk of forest investment. Physical risks are incorporated through a Monte Carlo simulation which considers fire, tornadoes, insect defoliation, and selected diseases. Financial risks are measured by using historical lumber prices, land values and management costs. The results of this methodology is a time series of annual rates of return for forest investment. An empirical example based on central hardwoods in west central Indiana is presented. The time series of rates of return for several different forest investments are compared to alternative investments in common stocks, bonds, and U.S. treasury bills. Two basic investor groups are assumed--farmers and nonfarmers. Four farm option--crops, hogs, crop/hogs, and dairy--are used in the investment models. Three investment models for the nonfarm investor and two investment models for each of the farm option are studied. Each investment model is then run through a portfolio analysis routine to select those investments which maximize investor utility at given level of risk aversion. Investor utility is defined as a quadratic function of investment return, with return variance as the measure of investment risk. Results from these models indicates that forest investment are desired by investors when risk is included. Forest investments are selected over a wide range of risk aversion by both nonfarm and farm investors. Also, analysis performed using data covering the past 10 years of inflation suggests that forest investment is becoming increasingly attractive to investors. Thus the inclusion of risk in investor preferences may provide an economic rationale for forest investment, explaining the revealed behavior of forest investors.

Degree

Ph.D.

Subject Area

Finance

COinS