Here's another thought experiment for you.
Suppose the government (or the stock exchange) changed the rules on investing to ban short-term trading. The mechanism for how they do this is not important, but it could be implemented, for example, by changing the capital-gains tax rules to tax short term trades at 100%, making them pointless. Let's say that they effectively prevented anyone from owning stocks for less than 3 years.
What would happen to the market?
Well, all the traders would leave except for the value investors. The day traders, momentum investors,
rumourtragists would all leave. This would remove all the noise from the price charts, leaving only the long-term signal. The price would then far more closely and more often be reflective of the intrinsic value of the stock.
But suppose, at the same time, we also created a secondary stock market that didn't have such rules, but instead allowed betting on whether the primary stock market prices price would go up or down.
Further more, let's create a third market, that allowed betting on whether or not the sum of the first 2 markets would go up or down.
I believe this to be a fairly accurate model of the today's stock market. As a model, it seems to serve the useful purpose of highlighting are number of key points. Firstly, that the day traders and momentum investors are playing a zero sum game. The above clearly shows this as the only money flowing into markets 2&3 comes from other "gamblers".
So where does the money come from in the primary market? I'm glad you asked! It comes from the customers of the companies for which the stock represent part-ownership. Money flows from the customers into the business. Some of this money goes out as costs, and what is left is profit. Some of this then gets distributed to the share holders as dividends, and some of it gets "owned" by shareholders in the form of retained earnings. Value investing is, therefore, a positive sum game.
Broadly speaking then, value investors make their money off the customers of the companies that they are part owners of, and the day traders try to make money off each other.
I'd much rather play the positive sum game than the zero sum game.
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>> Suppose the government (or the stock exchange)
ReplyDelete>> changed the rules on investing to ban short
>> term trading.
People would buy and sell futures/options, which would cancel out the rules.
If I buy a share of X one day for $9.00, and the next day sell an option to sell a share of X for $0.01 in three years, and get paid $10.00 for that option, I have effectively bought and sold the share (and made a dollar on it).
Likewise if I buy an option on a share, and sell
that option (or sell another option which cancels it out), then I have effectively bought and sold a share.
And if the government banned the trade of futures then they are effectively banning insurance.
Thanks for your comment Strawman.
ReplyDeleteI certainly agree that by banning the "gambling" aspects of the stock market, the gamblers would find another avenue to make their bets - whether that be futures, options, bet-fair, etc.
By trying to separate the zero-sum gamblers from the positive-sum investors, I was also trying to highlight to fundamental prices drivers of the stock market. That is, the base layer is the fundamental long term value, and the higher layers are the "bets" - in a similar way to sound frequencies can be split into the base frequency and higher harmonics, through the use of filters.
I find this useful, because whilst the higher frequencies are very noisy - essentially random - the base frequencies are quite stable and predictable - or at least they are for some companies...
Cheers,
Dave.