What is the Stock Market?

Written on August 25, 2008. Written by .

Wall Street
The aspects that nobody talks about.
Photo courtesy of Helico

Stocks are an extremely popular form of investment nowadays because they are easy to get into and they provide better average returns than safer investments like savings accounts and CDs. But where did stocks come from in the first place? Imagine you are a business owner and you need some extra cash. Probably the easiest option would be to go to a bank and ask for a loan. If the bankers aren’t willing to give you a loan, then you could try circumventing the banks by selling bonds directly to investors. Outside of seeking loans, another option you have is to sell a portion of your company. That is the idea behind stock, it is supposed to represent fractional ownership of a company – if you acquire more than 50% of the stock in a company then you gain control of it. When a company first chooses to sell stock, the event is called the initial public offering (IPO). If your company is worth a lot, then this could be a big source of cash.

The problem is that this notion of ownership has very little to do with the commonly accepted definition of ownership. We usually think that if you own something then nobody can take it away from you and you can choose how to use it. But when it comes to stock, until you get to the point of 50% ownership, you basically own 0% of the company. You simply own a certificate which could be used in a takeover of the company.

To see how stocks fall short, we should investigate what it would mean to own a fraction of a company. From an economic standpoint, a company can be thought of as an imaginary box created for the sake of legal accounting that encapsulates all the owners of the company. The revenue of the company flows into the box and is distributed to the owners in the box. The employees are outside the box; they are not part of the company itself, they just work for the company. If you are one of the owners of the company, then you deserve to get your fraction of the money that flows into the box. So if you own 1% of a company, then you should receive 1% of that company’s revenue. Now, this is the one point where I disagree with the economist Milton Friedman. In Free To Choose, he says that 1% ownership means you deserve 1% of profits and 1% of losses. But if that was the case, then whoever was managing the company could choose to spend more and reduce the profits to zero, which would completely nullify your ownership. Whereas if you controlled 1% of the revenue, then you would get to determine how the company spent that money, or you could just decide to take all that money for yourself. Of course the primary owners would probably have some kind of cost-sharing contracts to prevent free-rider problems.

So how do stocks compare with this natural definition of ownership? First of all, stocks don’t entitle you to any revenue or profits at all. If the board of directors decides, you may receive a quarterly dividend, but most of the time it is much less than your share of the revenue. Also, the board can choose to issue a secondary offering which will dilute your share. This means that you could buy 10% of the stock of a company, and then after a secondary offering all of a sudden you only own 5% of the stock of the company. Furthermore, a majority of shareholders (probably the management) can force you to sell your shares at a price you cannot choose in what is known as a forced buyout. This is clearly not consistent with our common notion of ownership.

Despite these concerns, I wouldn’t consider the stock market unethical. It’s just unfortunate that many investors think that they actually are buying ownership of a company when it is quite far from the truth (unless they can afford to buy a large fraction of the outstanding shares). The term “ownership” just seems slightly deceptive to me. This is similar to the problem with banks – people think their money is being put in a vault for safe keeping, when in reality you are giving away ownership of your money for investment in loans. Additionally, the stock market often has the effect of redistributing money from the poor to the rich because insiders and big institutional investors have a lot of advantages in the stock market. I would recommend reading a book called “The Secrets of The Street” to see how a lot of money is made legally and illegally by insiders on Wall Street.

So isn’t the stock market justified by the value it produces for the economy? Well, the stock market does produce a lot of value during the IPO phase because a company is getting a lot of money from investors who don’t need it as badly. But after all of the shares are sold in the initial public offering, the stock market doesn’t generate much value. The daily trading of stocks serves but one real purpose – setting the buyout price of the company, and this certainly doesn’t require thousands of trades a day. In a famous quote from the movie Wall Street (1987), Gordon Gekko says “It’s a zero sum game, somebody wins, somebody loses. Money itself isn’t lost or made, it’s simply transferred from one perception to another.”

But if stock trading isn’t producing any value, how can the price of the index keep going up? You could argue that it is because the values of the companies are increasing. But perhaps it is more direct to say that more money is flowing into the stock market because the price can’t go up unless demand increases. As time goes on, there are more people alive and more money in the economy, so more money ends up being used to purchase stocks. This makes the stock market resemble a pyramid scheme since its success is dependent on ever-increasing outside contributions. But in the end, there is no reason why it isn’t ok to trade stocks. I just think it is best to be aware of the nature of the stock market so that you aren’t taken advantage of. And if you have enough money to buy the majority of shares in a company, then you actually do get real ownership and that part of the stock system is legitimately awesome.

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1 Comment so far
  1. mspice August 25, 2008 8:15 pm

    It is interesting how perception seems to be the most important component of a stock price. For example, one value of a high stock price for a company is that it can borrow from banks an amount proportional to the total value of the shares the company itself owns. In other words, the value of the stock affects their credit. Of course, the stock price is always affected largely by outside investors and their perception. Certainly a company can generate a lot of excitement to artificially inflate their stock price (i.e. the dot com era) without it actually being tied to their value. Is it really common that people think owning stock implies ownership in the company? Aren’t most people aware that it is similar to most monetary systems in the sense that their stock only has value because of other people valuing it? The statement that the stock market has long term growth related to inflation and an ever increasing population is like a pyramid scheme is an interesting and as far as I can tell, correct observation.

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