Heyy. I’m from Australia, and my teacher keeps referring to Portfolio investment as disconnected to the real economy, and jst a form of gambling. (Casino Capitalism)
I am pretty sure there is more to it then that, i think it channels resources into the more efficient producers. But i cant figure out how.
He also states that the stock market is a zero sum game… thoughts ?
Here’s a great article by Robert Murphy about how stock speculation is beneficial to society.
Ask your teacher to explain the difference between speculating and investing.
This is going to be a bit long… but you asked a fairly broad question. I’ll give it a shot.
Speculating is the same as gambling. This is the “buy low - sell high” mentality where you don’t care about the underlying value of what ever you’re buying. You don’t want to own the item long term. You’re only buying it to sell it later at a higher price. For example, a couple years ago people would speculate to buy a house and watch the purchase price rapidly go up. Within a year or two they would sell the house and make a good return on their money. They relied on price appreciation and some sucker to come along and pay more for the house then he did. Then there’s investing. This is where you look at long term fundamentals for a sector in the economy and you put your money in that sector to work for you to grow. For example say the housing market has bust and prices are low, but don’t expect house prices to be going up for at least 5 years. A capitalist may determine that there will be demand for houses to rent. He/she buys a house for the purpose of renting it out for the next 20 years. Not to sell it when house prices rise, but to hold out long term for the cash flow generated from rent to pay for the mortgage and upkeep of the property. This is an investment.
Stocks are similar. Some people buy stocks because they heard the company may be a target for a take over and therefore stock prices will rise. Or maybe you buy gold mining stocks because you think the price of gold will spike up. You think the company stock will spike up too and that would be a chance to “sell high”. This buy/sell activity is really only trading. People put money in the market one day and take it out another. One person’s gain is another’s loss. This is speculation - like gambling. There are also other ways to make money off stocks without having to buy stocks. These are called derivatives. This is where you buy or sell contracts that entitles you or others to buy stocks or commodities at particular prices, but no one has to actually buy the underlying stocks or commodities. You can just buy & sell the contracts. The price that you can sell the contract for will go up or down based on the price movement of the underlying stock or commodity. These contracts are called futures contracts or stock options contracts. You never have to own the actual stocks or commodities. You only own the contracts that give you the right to buy or sell. The risk is that you put money in to buy these contracts but if the stock or commodity prices move in a direction unfavorable to the contract then the contracts can become worthless because you or no-one else will ever want to exercise / follow through / execute the contract. (I’m trying to avoid details here because there are call contracts and put contracts and you can write/sell or go long both types… which is outside the scope of this conversation). But my point is that this buying/selling of derivative contracts is true speculation/gambling… where you can loose all the money you put in if the stock or commodity price moves opposite the way you bet it would. If you were outright buying stocks at least you would own something and could hold it forever. All derivative contracts have a specified expiry date and therefore you can’t hold it long term.
Then there’s investing in a company. Say there is a company making bicycles. You investigate and determine there will be high demand but low supply of bicycles and you strongly believe it will be profitable to make and sell bicycles. You take your money and buy the company. You own the company for 15 years while you let the managers grow the company and make it successful. This is no different than buying stocks in a company that you have an understanding about and belief will have long term growth. You don’t sell if stocks go high. You hold it because you’re in for the long haul for long term growth.
As for portfolio investing, this is where you diversify your money into different sectors of the economy. Maybe you think Oil price will rise so you buy stocks of a couple oil companies. Then you think that cell-phones will be in big demand so you buy some high-tech companies that you believe will have good growth. Maybe you buy some government or corporate bonds just in case your stocks to fall in price, the bonds will continue to pay you money annually while you wait to get your purchase price reimbursed when the bond is matured. In portfolio investing you too can be an investor or speculator.
I’m not quite sure what is implied by calling it a “zero sum game”. Does he mean that when stock A goes up then stock B must go down? Does he mean that stocks may go up for the next five years buy then they will likely fall back to where they are today? Does he mean that money flows from bonds into stocks when investors are optimistic about the economy & stocks, but money flows out of stocks and back into bonds when investors are pesimistic about the economy? Today’s stock market bust has made most loose faith in investing all together. The truth is that depressions like what we’re seeing today are not normal. To say that stocks can’t go up long term I believe is false. Many stocks have drastically fell in price, but great companies didn’t fall as much as some of the bad ones. The strong companies will come out of the depression in a strong position and will still grow.
The economy is undergoing a severe price correction because of government and central bank interference in the economy. When the central bank (in the USA the Federal Reserve) makes credit available at interest rates not supported by the current savings rate then this creates inflation and cheap money. This promotes people to borrow money and speculate - which pushes prices higher and creates bubbles . People borrow more and speculate more and take on higher levels of debt. People even borrow money to buy stocks - called “buying on margin”. As the bubble grows there always has to be a bigger sucker to buy what someone else is selling. Someone is left holding the bag. When everyone becomes overloaded with debt and relies on cheap credit to remain profitable - eventually price inflation gets so high that the central bank has to raise interest rates to put strength back into the purchasing power of the money. This bursts the bubble and the economy enters a recession. Good investors understood this is how it works and chose investments out of harms way, or sold before the bust. Bad investors didn’t understand this and got hit by the bust.
Okayy, im getting a much better understanding
I understand how there is speculation and investing.
I understand how stock prices determine who controls the company in the most efficient way.
I understand, how stock prices are not just random numbers but a percentage of control to a company’s assets and dividends.
The part i dont understand is, the role of Non voting stock (portfolio investment) in an economic system
Say trader A, buys off trader B. This raises the stock price of a company.
Whats the benefit to the company if 100% of its stock is public (therefor it could not issue any more shares)? where is the efficient allocation of resources? Say trader A was correct, are there any other benefits to the economy ?.
The reference to a Zero sum game. Is similar to that of poker
Trader A makes money off Trader B. There is no net increase of wealth, the benefits A recieves is proportionate to the loss of trader B
When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle deposits with banks, are mobilized and redirected to promote business activity with benefits for several economic sectors such as agriculture, commerce and industry, resulting in stronger economic growth and higher productivity levels and firms.
It is this that im interested in. The above is a non sequitor, how is the money that goes from trader A to trader B going to “mobilize and redirect to promote business activity.” This is the part i do not understand, any help please. I feel i am close to an answer
the stock market gathers capital from many sources and directs it to fewer. The most productive and efficient companies will receive more of this capital(providing no malinvestment due to an inflationary boom), sinctheir stock would likely be the most appealing. There is no zero sum game, this process has created some of the welathiest companies in the world.
a company can always issue more shares.
why couldnt it?
I understand how stock prices determine who controls the company in the most efficient way.
I understand, how stock prices are not just random numbers but a percentage of control to a company’s assets and dividends.
The part i dont understand is, the role of Non voting stock (portfolio investment) in an economic system
Say trader A, buys off trader B. This raises the stock price of a company.
Whats the benefit to the company if 100% of its stock is public (therefor it could not issue any more shares)? where is the efficient allocation of resources? Say trader A was correct, are there any other benefits to the economy ?.
The reference to a Zero sum game. Is similar to that of poker
Trader A makes money off Trader B. There is no net increase of wealth, the benefits A recieves is proportionate to the loss of trader B
Let me try to clear a couple things up here.
Stock price does not control the company in any way, except indicate to the companies management the market does not approve of their decisions. This also reduces the companies ability to raise more capital by means of issuing & selling more new stocks.
Stock prices are not a percentage control of a companies assets & dividens. The stocks themselves are ownership of the company, but you owning those stocks give you no control. Control is entirely in the hands of the board of directors or management. The only control you, as a share holder, have is to sell your stocks in dissaproval to their management decisions. You cannot make any business decisions. But this works to your benefit as well considering if the company were to do illegal activities (embezzlement or fraud) then you as company owner will not be liable or imprisoned as a result. Also, you’re percentage ownership has nothing to do with the price but rather quantity of stocks you own. If the company has a total one million stocks outstanding, if you own one thousand of them then you own 0.1% of the company.
As for voting -vs- non-voting stocks? If you directly buy stocks of say General Electric then every now & then the company may have something for common share holders to vote on. Typically it’s like nominating someone new to the board of directors or some other change of management, etc.. If you own 0.1% of the company then you’re vote will count 0.1%. If you invest in mutual funds then you may own General Electric stocks as one of the underlying assets in that fund. The Fund manager will likely be the one who votes on such decisions. I wouldn’t call the voting process all that democratic. You as an investor with 0.1% of the vote don’t have much say considering there are other share holders with 30% or more ownership in the company. Only a few people own the biggest portions of the company and their votes usually sway the outcome of the vote. If the mutual fund manager has 5% of all issued General Electric shares in his fund then he will have control of 5% of the vote.
Trader A can buy from trader B and this may drive the price up. But it is not what makes prices rise long term. Pundits like Jim Cramer come on CNBC and tell people to buy buy buy. Then the heard of speculators go and buy the suggested company without knowing how much the company is actually worth. But then there’s another key player in the stock market. The short seller. These guys help keep prices at a level representing the true value of the company. Say a big bank has mutual funds and they hold General Electric stocks as part of their fund. They plan to hold their shares for a long term. If this bank is your broker then you, as a short seller, can borrow these shares. You think speculators are boosting up GE’s stock price more than it’s actually worth. You wouldn’t dare buy to own (long term) GE stocks at the going price - you believe it’s way overvalued. You can borrow GE shares and sell them to the market. For every seller there’s a buyer. Eventually the stock will not rise as much because there are increasing more short sellers coming into the market. Traders start to step back and re-evaluate their gamble and they too realize they’ve boosted the price too high and that it’s overvalued. They believe the price will now fall so they all start to sell their stocks. The price starts to fall. When the price falls back to a level which the short-seller believes is fair / reasonable for the true value of the company then he will buy back the stocks he sold, but at this cheaper price. He gives the stocks back to the bank where he borrowed them. This is called “covering your shorts”. The difference received when he originally sold the stocks and what he paid when he covered is his profits. Therefore, it is profitable to be a stock buyer as well as a stock shorter. Both types of speculators helps keep stocks at realistic prices.
What is the benefit to having a company that is 100% public? If you have a private bicycle company then you own all the profits but your ability to grow the company requires you to either wait & earn enough profits & save to slowly grow the company or take on large amounts of debt. Say it just became obvious that it is feasible to use carbon fiber to make a superior bicycle, and you want to explore it further but don’t have the capital to do so. Groth prospects look good if only you had the capital to invest. If you had to invest your own money then - say you were to go without a salary for one year to fund this venture - you would likely starve. Go in debt? Or let someone else invest? Other investors would own the profits but overall you would do better too because the company would be more profitable to all company owners. So you let the company go public. You create a bunch of shares and sell them on the market. Investors take their savings and give to you so you can grow the company. Their savings / investment is what pays your salary for the next year while you research, develop and grow the company. These new investors / share holders are the ones taking on all the risk of venturing into the carbon fiber bicycle business. Not you, who are still getting paid your salary. The investors are the ones who have to wait for future revenue to get paid by dividend payments or stock price appreciation. You, as manager, are taking on the risk of challenging your ability to manage and forecast the market for carbon fiber bicycles. If you make good forecasting and management decisions then your investors and yourself will be rewarded. If you fail then it is your reputation as manager & forecastor that gets hurt while it is the investors money that is lost on all that carbon fiber & wages that you couldn’t sell as bicycles. Also, the number of stocks issued are never fixed or limited. Company issue new stocks every now & then when they want to raise money without going into debt. Share holders don’t like this because it waters down their own stocks. The advantage is that money raised is not a debt liability that must be paid back by increased future revenues. The buyers of these new stocks are other capitalists / investors who are taking on the risk of whether or not the company will have increased profitability. If instead the company borrowed & took on debt then it would be the management and existing share holders that risk not being able to pay back the debt by failing to have increased future profits.
As in zero sum game, trader A making money off trader B, yes I can see this. But this is what happens in trading. Much like flipping houses to turn a profit except the flipper may put in carpet, paint the walls and add some other value. The stock traders are just taking from person A’s pocket and putting in person B’s pocket. There isn’t necessarily any true underlying appreciation in the value of the company during the transaction. If the stock goes up $1 on Monday but back down on Tuesday then that’s an opportunity for a trader to profit from market volatility. But if you, as an investor, bought Microsoft shares from a trader for $2 each in 1986 and held them for 20 years I am sure you would have observed appreciation. But that’s because the company was successful and grew over that 20 year period. Between Monday and Tuesday the company didn’t grow enough to affect stock price. Market volatility changed stock price because perhaps more traders went on vacation Tuesday or because war broke out somewhere in the world.
Ohhh, i see a company can continue issuing unlimited shares, further diluting current share holders
that changes everything! Thanks everyone, All your answers were very good.