Is the Stock Market a Positive-Sum Game or a Ponzi Scheme?

[Tosh5457]

Is stock market a positive-sum game?

As an example, let's say that in an IPO, an investor X buys all the shares, let's say 10, for $10 each (in the primary market). He spent $100, and those $100 went to the company. Next, there appears a bid of 10 shares (now at the secondary market) at $11. The investor X sells all his 10 shares to that bidder Y. Now the investor X has a profit of $10. Now let's say there's a bid for 10 shares at $12. The investor Y sells his 10 shares and made a profit of $10. For this to continue indefinitely there always need to be more money to be invested. If there weren't any other bidder, the shares wouldn't have any value and the last buyer would lose an amount of money equivalent to what the others won, making it a zero-sum game.

So is the stock market just an elaborate Ponzi scheme? Or it's a positive-sum game (excluding fees)? Excluding dividends of course.

 

[russ_watters]

A stock market is just a place people go to trade stocks.

A stock is a piece of ownership of a company. What you are missing is that the value of a company is not static. A person will not pay $12 for something someone else just bought for $10 unless he has reason to believe the value of the company is higher. And that's how stocks gain value. If Apple earned $1 billion last quarter but $2 billion this quarter, ownership of those earnings is now worth twice as much.

 

[phinds]

Does stock market create wealth?

No, not a bit of it. COMPANIES create wealth. The stock market just provides liquidity for the movement of ownership of that wealth.

EDIT: the stock market does HELP in the creation of wealth, thought, because the liquidity it provides gives (existing, known) companies a way to raise money for new projects by just issuing new stock. This money will (the company and stockholders hope, at least) provide further growth for the company.

 

[Tosh5457]

A stock market is just a place people go to trade stocks.

A stock is a piece of ownership of a company. What you are missing is that the value of a company is not static. A person will not pay $12 for something someone else just bought for $10 unless he has reason to believe the value of the company is higher. And that's how stocks gain value. If Apple earned $1 billion last quarter but $2 billion this quarter, ownership of those earnings is now worth twice as much.

But as you said, investors will only pay more if they perceive it has a higher value. But it's just a matter of perceiving, because a company earning more this quarter than in the last doesn't mean the stock will automatically gain value. There are many cases where this doesn't happen, just before bear market start for example. Even companies who have increased revenue every quarter can have their stock fall down a lot in value for a long period of time. If the market only had people who didn't pay attention to the fundamentals of companies, there wouldn't be any relation between increased earnings and rise of stock price...

No, not a bit of it. COMPANIES create wealth.

Would you say it's a zero-sum game, if you exclude dividends (dividends transfer money from the company to the investors, so that obviously makes it a positive-sum game)? In trading everyone seems to think the stock market creates wealth...

 

[russ_watters]

But as you said, investors will only pay more if they perceive it has a higher value. But it's just a matter of perceiving, because a company earning more this quarter than in the last doesn't mean the stock will automatically gain value.

Unless the investors are stupid (and admittedly sometimes they are) or have a good reason why prospects for the future will be different, it will. That's why investment advisers have a target for a reasonable stock price to earning ratio: http://en.wikipedia.org/wiki/Price–earnings_ratio

The place where it gets fuzziest is the future prediction element in stock pricing. But you'll notice from the graph on the P/E ratio page that it should have been easy to predict the 1929 and 2000 crashes based on the ridiculously high P/E ratio.

There are many cases where this doesn't happen, just before bear market start for example. Even companies who have increased revenue every quarter can have their stock fall down a lot in value for a long period of time.

Right: that's based on prediction of future value.

And the bull/bear is cyclical. The cycles get smoothed-out over the long term, so you're focusing on the wrong thing if you want to examine whether over the long-term the stock market is a pyramid scheme or zero-sum game. (pyramid schemes never temporarily lose value)

If the market only had people who didn't pay attention to the fundamentals of companies, there wouldn't be any relation between increased earnings and rise of stock price...

Right. So since we know that the stock market mostly includes people who do pay attention, it does relate to earnings.

Would you say it's a zero-sum game, if you exclude dividends (dividends transfer money from the company to the investors, so that obviously makes it a positive-sum game)? In trading everyone seems to think the stock market creates wealth...

That's what I just explained: No, it is not a zero sum game. The value of the shares rises over time because the value of the companies rises over time.

 

[russ_watters]

I think you may be getting too far down in the weeds on this. All you need to answer whether stocks are a zero sum game is to answer a simple question: Does the actual value of the companies remain constant over long periods of time (after filtering out short term fluctuations)?

 

[Tosh5457]

Does the actual value of the companies remain constant over long periods of time (after filtering out short term fluctuations)?

I think you're missing an important point - the only mechanism that companies have to transfer money to stock holders are dividends. Having 1% of the shares of a company doesn't mean you'll get 1% of the wealth of the company (only 1% of the dividends the company decides to give its stock holders). If a company doesn't give dividends, trading the shares of that company is just speculation like in any other instrument (forex, futures, etc), which is a zero-sum game. If a company's value rises 10-fold in a period of time, if it doesn't give dividends, it won't transfer any of that wealth to the stock holders. So owning shares of that company isn't owning the wealth of it. The shares' price would still rise of course, but like that example I gave attempts to show, you can't create wealth just by speculating...

If the market only had people who didn't pay attention to the fundamentals of companies, there wouldn't be any relation between increased earnings and rise of stock price...

The point I wanted to make is that what makes the shares of a company move is based on the future expectations of the investors, not the wealth of the company itself. That's also how currencies and commodities rise/fall, and speculating in them is a zero-sum game in respect to the profits.

 

[russ_watters]

You are implying that stocks have no intrinsic value and that is simply false. The fact that at any given time, the price you can by or sell at changes due to speculation does not change the underlying fact that there is real value there.

Consider a bar of gold. The price on any given day can change due to speculation, but regardless of those changes, it is still a bar of gold. The main difference between a company and a bar of gold is that companies grow while bars of gold do not. That's why over time stocks typically go up, but gold prices do not.

And yes, day to day price fluctuations are largely due to changing expectations, but these average out to zero, converting to reality over the long term as the expectations are either met or not. You are improperly mixing together short term fluctuations (with no growth) and long term growth.

 

[russ_watters]

And it is still wrong to try to disconnect share price from company value. I have to ask: do you think it is pure coincidence that companies with more earnings have higher stock values than those with less?

Let me ask another way: do you accept the fact that stock values and company values are at least statistically corellated?

 

[arildno]

OP asked if stock trading was like a Ponzi scheme. That is a very odd misconeption, since in the ponzi scheme, the ONLY source of wealth for the share holder would have been from eager, new shareholders.
A company has a value of its own that brings a stability, predictability in the earnings of the owner, whether or not new, prospective owners join the game.

 

[russ_watters]

OP asked if stock trading was like a Ponzi scheme. That is a very odd misconeption, since in the ponzi scheme, the ONLY source of wealth for the share holder would have been from eager, new shareholders.
A company has a value of its own that brings a stability, predictability in the earnings of the owner, whether or not new, prospective owners join the game.

Yes, Ponzi scheme is the wrong term. I think the OP was really asking if the increasing value is all just some sort of illusion based on irrational/ignorant speculation. If people believe stocks should gain value, they will gain value, regardless of if the companies' earnings increase.

But the statistical correlation between share price and company earnings is a fact. It exists. It would be very odd if that fact was just a coincidence, similar to saying that f=ma is meaningless and the noticed correlation between the terms is just a coincidence.

 

[BWV]

Trading stocks is a zero sum game relative to the market as a whole, as the average dollar invested in stocks gets the market return less costs

But unless you believe that wealth creation in the broad economy is a zero sum game then you can't claim that equity markets are zero sum. Furthermore the bond markets in aggregate would also have to be zero sum

 

[borodatiy]

No, not a bit of it. COMPANIES create wealth. The stock market just provides liquidity for the movement of ownership of that wealth.

EDIT: the stock market does HELP in the creation of wealth, thought, because the liquidity it provides gives (existing, known) companies a way to raise money for new projects by just issuing new stock. This money will (the company and stockholders hope, at least) provide further growth for the company.

Company raises money via IPO, secondary stock market doesn't impact companies balance sheet. If Apple stock drops to $1 tomorrow, as a company Apple will not feel it, at least until it tries to issue more stock.

 

[clfst17]

If there weren't any other bidder, the shares wouldn't have any value and the last buyer would lose an amount of money equivalent to what the others won, making it a zero-sum game.

I don't think it's zero sum if you have a randomized portfolio of stocks from different sectors. In the case of a single stock, yes it's possible for it to have no value. But unless the entire market crashed all at once or there was no demand for goods and services (human extinction), certain stocks will always have value and thus be expected to grow in the long run. So it's positive sum.

 

[Tosh5457]

And it is still wrong to try to disconnect share price from company value. I have to ask: do you think it is pure coincidence that companies with more earnings have higher stock values than those with less?

Let me ask another way: do you accept the fact that stock values and company values are at least statistically corellated?

No it's not a coincidence, and yes stock values and company values are correlated. But take futures bond trading: if a country's government is fiscally solid the yield rates of government bonds are expected to go down. But it will be a zero-sum game no matter how you look at it (excluding the interest, equivalent to dividends in stocks), because in derivatives when you buy a contract there has to be someone going short on it. There are fundamental reasons for the yield rate to go up or down in the long-term, but that doesn't mean it's not a zero-sum game. What you're saying is that because stock trading is designed differently than derivatives (and even though the only way for companies to transfer their wealth to stockholders are dividends), it's not a zero-sum game. Then I could also design a system to trade bonds like stocks and it would be a non zero-sum game?

A company has a value of its own that brings a stability, predictability in the earnings of the owner, whether or not new, prospective owners join the game.

Yes Ponzi scheme is the wrong term, because in the stock market there can be losses in between the profits. But what you're saying it's just not true: if no new investors want to buy a certain stock, the stockholders will only hold a piece of paper that isn't worth anything unless anyone wants to buy it. This is my point: if there is no demand for the stock you hold, you only hold a worthless piece of paper that has no value. Therefore there always need to exist investors willing to buy that stock for it to have value(i.e. to get return), and that's a characteristic of a scheme. It's just not as simple as a pyramid scheme...

 

[BWV]

if no new investors want to buy a certain stock, the stockholders will only hold a piece of paper that isn't worth anything unless anyone wants to buy it. This is my point: if there is no demand for the stock you hold, you only hold a worthless piece of paper that has no value. Therefore there always need to exist investors willing to buy that stock for it to have value(i.e. to get return), and that's a characteristic of a scheme. It's just not as simple as a pyramid scheme...

I think you are missing the fact that a stock certificate is an ownership claim on a set of productive assets. If I own a share of Exxon stock then I own that percentage of the company's net assets - if, all else being the same, no one wanted Exxon stock and the share price fell to few pennies, then someone could buy up all the shares and for a small price own a company that generates billions in cash flow every year.

 

[jim mcnamara]

Maybe Tosh5487 is talking about stock kiting - an illegal scheme to artificially inflate as stock trading price. In that case the stock does not represent a true value in the sense that BWV explained.

This should be obvious, but in the US: the SEC and the Sarbanes-Oxley Law make it very, very hard to misrepresent a company assets (like Enron did). And very, very painful and financially unrewarding when you get caught (like Enron did).

So I think BWV's point is extremely solid. And a counterexample is needed from Tosh to have hope of salvaging his argument. It needs to cite some specific, ubiquitous property that is exemplified by actual stocks. From SOX-compliant companies, please.

 

[OmCheeto]

Maybe Tosh5487 is talking about stock kiting - an illegal scheme to artificially inflate as stock trading price. In that case the stock does not represent a true value in the sense that BWV explained.

This should be obvious, but in the US: the SEC and the Sarbanes-Oxley Law make it very, very hard to misrepresent a company assets (like Enron did). And very, very painful and financially unrewarding when you get caught (like Enron did).

So I think BWV's point is extremely solid. And a counterexample is needed from Tosh to have hope of salvaging his argument. It needs to cite some specific, ubiquitous property that is exemplified by actual stocks. From SOX-compliant companies, please.

You sound quite knowledgeable in this topic. I don't mean to change the subject, but I just lost the equivalent of 10% of my annual salary the other day in a stock. It's IPO was $2 billion. I was buying shares at $20 a pop, and had no fear, as they made an exceptional product, and planned on selling at $30/share. Over the last 4 years, the price went down to 5 cents a share. And now the company is bankrupt. Though shares are still being traded over the counter for 8 cents a share, yielding a market cap of around $11 million.

The problem with the picture though, is that there is another company willing to buy my company for over $500 million.

Does anyone know what it means when there is a 50:1 difference like that?

Or should I start a new thread?

(I doubled my money in GE. So yes, gambling in the stock market does create wealth: $200! )

Unless the investors are stupid (and admittedly sometimes they are) or have a good reason why prospects for the future will be different, it will.

Raises hand sheepishly...

 

[BWV]

I just lost the equivalent of 10% of my annual salary the other day in a stock. It's IPO was $2 billion. I was buying shares at $20 a pop, and had no fear, as they made an exceptional product, and planned on selling at $30/share. Over the last 4 years, the price went down to 5 cents a share. And now the company is bankrupt. Though shares are still being traded over the counter for 8 cents a share, yielding a market cap of around $11 million.

The problem with the picture though, is that there is another company willing to buy my company for over $500 million.

Does anyone know what it means when there is a 50:1 difference like that?

:

If the company is bankrupt then its equity is likely worthless, but its bonds are not as they have a priority claim on the assets. The existing equity owners only see a recovery if all the bondholders get paid in full, which typically does not happen. the $500 million number you saw likely represents an offer to the bondholders which would give them a partial recovery of their losses

 

[Tosh5457]

I think you are missing the fact that a stock certificate is an ownership claim on a set of productive assets. If I own a share of Exxon stock then I own that percentage of the company's net assets - if, all else being the same, no one wanted Exxon stock and the share price fell to few pennies, then someone could buy up all the shares and for a small price own a company that generates billions in cash flow every year.

That argument was made before in the thread and I replied to it. If you exclude dividends, by owning shares of a company, and in a way that it doesn't allow you to control the company and therefore get the profits from the company by other mechanism than dividends (that doesn't happen in the stock market, that's a takeover) you don't own anything of the company. If you have 10% of the shares of a company, can you sell 10% of their capital? Can you even sell anything that the company owns to make a profit? You can't, because you don't own anything of it. So how is that claim on the company's assets going to give you profit if there aren't dividends?
I don't have to give a counter-example, because what he's talking about is a take-over and stocks with voting rights, not the usual preferred stocks that are traded in the stock market.

I'm going to put this in more concrete terms:

If I define profit of an investor as money spent or received in the stock market, if I buy $1000 of a stock my profit will be -$1000 and the profit of the seller will be +$1000. Using that definition it's obvious that it is going to be a zero-sum game in respect to the profits. Even though this definition can seem strange, it comes from the fact that shares only have value if anyone wants to buy them. So when you buy $1000 of shares, you just lost $1000, which can be regained or not in the future.

If I define profit of an investor in a given trade as:
In case of buying, profit = 0.
In case of selling, profit = Price that the investor sold the stock - Price that the investor acquired the stock
This is the usual and intuitive definition of profit.

Now imagine that a stockholder X has 100% of all the preferred shares (no voting right, therefore no other mechanism to get money from the company other than dividends) of a company. That company has 10 shares of $10 each (for sake of simplicity). Let's say this system has $1000 and investors X(which is the current stockholder) and Y.

Balance of X = $0
Balance of Y = $1000

Now investor Y acquires the 10 shares for $100 each.
Profit(X) = 10*$100 - 10*$10 = $900
Profit(Y) = $0

The investor X now has $1000 and buys all the shares to Y for $70 each.
Profit(X) = $0
Profit(Y) = 10*$70 - 10*$100 = -$300

Now Y has $700 and X has $300 in his balance plus all the shares.

Total profits of X = $900
Total profits of Y = -$300

With profit defined like this, it's easy to show that the sum of the profits of the 2 investors can never be greater than $1000.

X balance = $300
Y balance = $700

Money that Y has in its balance + Money that X has in its balance = $700 + $300 = $1000.

Variation of X balance = Final value - Initial Value = $300 - $0 = $300
Variation of Y balance = $700 - $1000 = -$300

Sum of the variations of balances = $0

Conclusions: The sum of the money in the balances of the investors is equal to the money in the system. From that it follows that if the money in a given system doesn't vary, the sum of the variations of the balances of the investors is always $0. If it varies by an amount Δx, the sum of the variations of the balances of all investors will be Δx.
For a given system, the stock market is a zero-sum game in respect to the balances (which is what's important after all, because it's the money investors actually own). In a varying money system, as in a real scenario, it's not a zero-sum game, but there isn't any creation of money either (just like there isn't energy creation in an open system). In other words, what one gains, came from another one's pockets, which was what I was attempting to argue, although with wrong terms.

This could be proven for the general case, if any of you has the patience go ahead

 

[BWV]

That argument was made before in the thread and I replied to it. If you exclude dividends, by owning shares of a company, and in a way that it doesn't allow you to control the company and therefore get the profits from the company by other mechanism than dividends (that doesn't happen in the stock market, that's a takeover) you don't own anything of the company. If you have 10% of the shares of a company, can you sell 10% of their capital? Can you even sell anything that the company owns to make a profit? You can't, because you don't own anything of it. So how is that claim on the company's assets going to give you profit if there aren't dividends?

the fact is that somebody could buy 100% of the stock (or more realistically a controlling interest) and then unlock the value of the company. More simply, all the small owners could just join together and elect a board of directors that would take steps to deliver value such as initiating a dividend or share buyback policy. This stuff happens all the time.

your example merely shows that accounting entries for sales and purchases of stock net to zero, as they must. Futhermore your example of a preferred share that pays no dividends and has no voting rights is ridiculous - you might as well imagine perpetual maturity bonds that pay no interest. No such financial instrument would ever find a buyer - preferred shares are a hybrid security that pays a fixed dividend.

I am not sure what you are trying to argue in this thread. Your position is inconsistent - you seem to argue that the stock market is a ponzi scheme except for the payments of dividends. This admission is sufficient to negate every other argument you made as

A) the value of a stock is the present value of if future dividends (Stock Price = div / r-g , where r=discount rate and g=growth rate of dividends)

B) company dividends come from money earned in the real economy which is not a zero sum game

C) if a stock does not currently pay a dividend, it may do so in the future. Shareholders will accept a lack of dividend payments for a new, rapidly growing company that needs capital to expand, but will require dividends once that company reaches maturity (just look at the fact that companies like Microsoft and Oracle are now paying dividends)

 

[OmCheeto]

...In a varying money system, as in a real scenario, it's not a zero-sum game, but there isn't any creation of money either (just like there isn't energy creation in an open system).[/B] In other words, what one gains, came from another one's pockets, which was what I was attempting to argue, although with wrong terms.

This could be proven for the general case, if any of you has the patience go ahead

Sorry. Listening to opera at the moment. Have no patience..

 

[Tosh5457]

the fact is that somebody could buy 100% of the stock (or more realistically a controlling interest) and then unlock the value of the company. More simply, all the small owners could just join together and elect a board of directors that would take steps to deliver value such as initiating a dividend or share buyback policy. This stuff happens all the time.

your example merely shows that accounting entries for sales and purchases of stock net to zero, as they must. Futhermore your example of a preferred share that pays no dividends and has no voting rights is ridiculous - you might as well imagine perpetual maturity bonds that pay no interest. No such financial instrument would ever find a buyer - preferred shares are a hybrid security that pays a fixed dividend.

I am not sure what you are trying to argue in this thread. Your position is inconsistent - you seem to argue that the stock market is a ponzi scheme except for the payments of dividends. This admission is sufficient to negate every other argument you made as

A) the value of a stock is the present value of if future dividends (Stock Price = div / r-g , where r=discount rate and g=growth rate of dividends)

B) company dividends come from money earned in the real economy which is not a zero sum game

C) if a stock does not currently pay a dividend, it may do so in the future. Shareholders will accept a lack of dividend payments for a new, rapidly growing company that needs capital to expand, but will require dividends once that company reaches maturity (just look at the fact that companies like Microsoft and Oracle are now paying dividends)

It's a good example, and I'll explain you why: most shares traded are preferred shares (which means they don't have voting rights), and since my first post on this thread I always said excluding dividends. If you want to account for maybe 0.1% of the shares traded ok it's not a good example, but it's a good example for the other 99.9% of shares traded. My point is to show that the stock market doesn't create wealth if there aren't dividends, which is a myth widely accepted by stock traders.

You didn't read all my posts, I corrected the part of the Ponzi scheme. I admit my position looks inconsistent, because I was using the wrong terms. You can just see my last post to understand... But your position seems inconsistent as well, you seemed to drop the argument that owning a stock is like owning a part of the company and instead focused on the dividends when I said on all my posts I'm excluding dividends, and that including dividends it's a positive-sum game. Somehow I get the impression your motive for posting is just to show me wrong, not because you're interested in the topic.

 

[BWV]

You are not correct, most shares traded are common shares with voting rights. Preferred shares have both a fixed dividend and liquidation preference

You cannot create some wildly unrealistic conditions like no dividends or voting rights and then extrapolate this to the real world where those conditions do not hold

 

[Tosh5457]

You are not correct, most shares traded are common shares with voting rights. Preferred shares have both a fixed dividend and liquidation preference

You cannot create some wildly unrealistic conditions like no dividends or voting rights and then extrapolate this to the real world where those conditions do not hold

As I said in my last post, my point was to debunk the myth that the stock market creates wealth, even if one doesn't account for dividends. Many stock traders actually believe that, hence my interest in it. My point wasn't to show that in the real stock market where there are dividends it's a zero-sum game, as you seem to think. As for voting rights, the common stock trader and many of the big traders don't use it, the great majority are just speculators...

 

[BWV]

The stock market in aggregate reflects wealth created in the real economy and contributes to its creation by channeling savings into productive investment. Trading stocks is a zero sum game relative to owning the entire market (say through an index fund) as the average invested dollar must get the market return less expenses

 

[OmCheeto]

If the company is bankrupt then its equity is likely worthless, but its bonds are not as they have a priority claim on the assets. The existing equity owners only see a recovery if all the bondholders get paid in full, which typically does not happen. the $500 million number you saw likely represents an offer to the bondholders which would give them a partial recovery of their losses

I don't know anything about bonds.

But here's the latest news on my company:

Posted: Dec 09, 2012 1:59 PM PST
If the deals are approved by the court, the shares will be worthless. That's because proceeds from the sale of the two parts of [Om's loser company] would be less than the company owes its creditors.

I guess I'll have a $4000 tax write off for the year. Yay!

Just in time for post christmas sale bargains.

 

[BWV]

its not a good sign when your battery fails during the Consumer Reports test ;)

but you can only use the loss against other capital gains on passive investments, so unless you have other winner stocks your loss is of no use (but you can carry it forward and use it against future gains on stocks)

 

[jim mcnamara]

@Om Cheeto -
The fact is that a large percent of transactions on the NYSE are automated, about 50% of volume, so called HFT:
http://topics.nytimes.com/topics/re...high_frequency_algorithmic_trading/index.html

Overall,70% of the NYSE volume is algorithmic based trading (see ted.com link below)

These folks are making huge volume trades in millseconds. If you Google for the term "quant" you can get an idea about this whole arena.

The point is the HFT or maybe "quant"-driven institutions are the ones who make the megabucks. Of course they are also having to back their purchases and sales with real liquidity. It means two things:
1. as a private investor you are at a huge disadvantage if you want to trade stocks to make money. You can invest well and come out ahead, don't get me wrong. Chances of you catching a rising star are diminished, since the star will rise in millseconds.

2. you will probably fare better longterm if you have the quants (or whoever) on your side, using your money to make millions and giving you a chunk. This probably means investing with funds. I don't know which ones, and some of them do tank.

A really interesting discussion of this whole deal from a geek perspective:
http://www.ted.com/talks/kevin_slavin_how_algorithms_shape_our_world.html

 

[OmCheeto]

but you can only use the loss against other capital gains on passive investments, so unless you have other winner stocks your loss is of no use (but you can carry it forward and use it against future gains on stocks)

Sorry, but I believe Russ was talking about me when he mentioned "stupid".

My other stocks have netted me less than zero. (I keep it around 10, as I can't even find the time to monitor 1)

My mentor who got me interested in investing is now the director of risk management in one of the largest holding companies in my area. I think it was he that told me not to "invest with a conscience". I of course, ignored his advice. He's a friend on facebook. He scuba-dives routinely in the Caymens. I fart in the bathtub.