The stock market is not a zero sum game because stock trades are not only about maximizing portfolio value. If I sell a stock because my risk tolerance no longer allows me to hold it to someone who wants to enjoy the associated risk premium, then there are gains from trade and we both benefit from the transaction. Likewise, options and futures are not zero sum because if I want to hedge my position by selling options to someone who wants to speculate, there can once again be gains to trade to both parties.
If the stock market is zero sum game the entire world economy is a zero sum game and of course it is not. Productivity growth makes it not. Why would a particular type of ownership (ie listed stock) make it zero sum? If I own a factory and I discover that if I do it in another way then i produce twice as much with the same amount of inputs, am I not then wealthier? Or I could sell my products for half the price and everybody buying my stuff is a little bit wealthier than before. If my factory is owned by many shareholders and listed on the stock market the same reasoning of course apply. It is not based on future production alone, my earnings and then my dividend improve as my productivity improves (unless the competition is so strong that all gains go to the consumer, which then is the real winner). Each year my dividend increase and to boost it even further in the future I invest some of my earnings to get even more dividends but that is not saying that the present is of no relevance.
double post
If you adjust stock returns for growth in GDP, the stock market would be a zero sum game, I think.
It may help to clarify the discussion if the question was rephrased to include the secondary market only.
There is an aspect of the stock market that is zero sum and an aspect that is not. CAPM and other asset pricing models divide the market into returns from beta, which is not zero sum, and returns from alpha, which is. Now the flaw in one of the earlier posts (bromion’s, IIRC) is that although supply and demand push prices up and down, sometimes increased demand is driven by the fact that the stock represents an undervalued asset that has become recognized, and sometimes it’s just a mob exuberance that "yay, stocks are good. Both processes can drive the price up, but in the first case, the demand is following the increase in stock value, and in the latter case, demand is simply pushing the price around. A simple way to see how company wealth translates to an improved stock price is to use a dividend discount model. Assume for the moment that a company pays out 100% of earnings as dividends. The stock price reflects the present value of that (approximately infinite) dividend stream. Now assume that the company discovers a process improvement that allows them to produce the same product mix at a lower price. Wealth is created there. The company can try to sell at current prices and have higher earnings. That means than the dividend stream from that company is now more valuable. The stock price will rise, since the next person who sells the stock for whatever reason they need to will demand a price that reflects this new value. In practice, it generally takes some time for knowledge of the process improvements to spread through the investmen community and there is some disagreement on what the earnings streams will actually be or what the appropriate discount rate is, but the change in price still reflects the actual creation of wealth in the form of higher company earnings. It does not need “new capital” to enter the market. Another outcome of the a process improvement is that the company could lower the prices of it’s products to reflect the cheaper production costs. In this case, company earnings would not necessarily improve unless the lower price resulted in increased demand. However, consumers would then have extra money left over than is availabe for other uses. There are several ways they can use this new surplus wealth. They could consume more I other goods, pushing up other stock prices beacause those companies now have higher revenues. They could invest it in the market, which would lower the cost of capital for companies. They could save it in a bank, which would in turn lend it out to support other potentially productive activities. So misvaluation and irrational exuberance does create some zero-sum qualities to stock markets, but it is not a true zero-sum game because there is an intrinsic value to stocks that does increase as the result of process improvements and wealth creation.
Thanks for the thoughtful reply, bchadwick. > Now the flaw in one of the earlier posts > (bromion’s, IIRC) is that although supply and > demand push prices up and down, sometimes > increased demand is driven by the fact that the > stock represents an undervalued asset that has > become recognized, and sometimes it’s just a mob > exuberance that "yay, stocks are good. Both > processes can drive the price up, but in the first > case, the demand is following the increase in > stock value, and in the latter case, demand is > simply pushing the price around. This is a false dichotomy. It doesn’t really matter why stock prices move up or down. The only reason they do move up or down is perception that leads to capital inflows – I buy a stock because I believe it will be worth more in the future, at which point I may sell it and collect the capital gain. Whether my perception is based on solid fundamentals or outright speculative mania is not particularly germane. > A simple way to see how company wealth translates > to an improved stock price is to use a dividend > discount model. Assume for the moment that a > company pays out 100% of earnings as dividends. > The stock price reflects the present value of that > (approximately infinite) dividend stream. I agree with this, but I did stipulate in the original post that I was excluding dividends and commissions. Many stocks do not pay dividends, so its hard to use this as an argument for the aggregate stock market (although I do agree with your logic for dividend paying stocks). Also, whether a company pays dividends or not, new capital is needed to cause the price to rise. The only way prices go up is if people bid them up. For a sustained price increase that reaches new all-time highs to occur, a new all-time high amount of capital must enter the stock. The market cap is the market cap, anyway you want to cut it. > Another outcome of the a process improvement is > that the company could lower the prices of it’s > products to reflect the cheaper production costs. > In this case, company earnings would not > necessarily improve unless the lower price > resulted in increased demand. However, consumers > would then have extra money left over than is > availabe for other uses. This is an economic benefit and a social benefit, but it doesn’t directly create wealth in the stock market. There are several ways > they can use this new surplus wealth. They could > consume more I other goods, pushing up other stock > prices beacause those companies now have higher > revenues. No. Consumption in and of itself doesn’t increase stock prices. Higher consumption and earnings growth influences the perception of a stock’s value, thereby creating demand for the shares. The increase in the share price is a second order effect, not a primary effect. They could invest it in the market, > which would lower the cost of capital for > companies. They could save it in a bank, which > would in turn lend it out to support other > potentially productive activities. Again, I see where you are coming from with this, but I don’t agree. This creates a positive impact on economic growth which is beneficial to society. It does not directly impact share prices though except through our *perceptions* about what it implies for share prices. We can all agree that a lower WACC will increase share prices, but it doesn’t actually happen unless people bid the shares up (i.e., the exchange doesn’t have some proprietary formula that includes WACC and results in increased share prices automatically without capital inflows). > So misvaluation and irrational exuberance does > create some zero-sum qualities to stock markets, > but it is not a true zero-sum game because there > is an intrinsic value to stocks that does increase > as the result of process improvements and wealth > creation. My point is that the intrinsic value is abritrary and that you are assigning meaning to the value based on what you define as fundamental value and speculative value. I’m saying it doesn’t really matter what people are using to determine value (if they are determining it at all); the only thing that matters is capital flows in and out of the stock. This is important, because if no value is actually being created, then people who better understand what perceptions are driving the market (and the reality of the company / product / market / situation in question) can profit at the expense of other investors.
“Say that the company is cooking the books and making the numbers look great, so the stock rises to 300, which necessarily means that people are putting more capital into the shares (it doesn’t rise out of thin air). At 300, the knowledge that the company is cooking the books becomes public and the shares drop to 0. The guy who bought at 300 provided a lot of liquidity to anyone selling at that price. And as people are dumping the shares, they are effectively taking liquidity out of other people who bought the shares along the way to the rise to 300.” I’m not sure you understand how the stock market works. If the market cap of a company goes from $100M to $200M, that doesn’t (necessarily) mean an additional $100M went into the stock. Heck, I could take some $100M companies and probably double their market cap with only $500K, through some incredibly sloppy and manipulative trading. Regarding your MSFT example, the market cap reflects the consensus of all investors of the forecast cash flow the company will generate, discounted at an appropriate rate. It might seem arbitrary, but it’s not. Intrinsic value can be tough to pin down, but it is also not arbitrary. If it gets cheap enough in an absolute sense, private capital will flow in and take the company over. They will earn extraordinary returns because of the cash flow the company produces. This fact should prevent the stock from deviating too far from intrinsic value, but oddities to happen. This is why I say again your argument is really about efficient markets and has nothing to do with the stock market creating value. Do you think the world would be a better place if we didn’t have a stock market? What sort of system would you replace it with?
“Say that the company is cooking the books and making the numbers look great, so the stock rises to 300, which necessarily means that people are putting more capital into the shares (it doesn’t rise out of thin air). At 300, the knowledge that the company is cooking the books becomes public and the shares drop to 0. The guy who bought at 300 provided a lot of liquidity to anyone selling at that price. And as people are dumping the shares, they are effectively taking liquidity out of other people who bought the shares along the way to the rise to 300.” I’m not sure you understand how the stock market works. If the market cap of a company goes from $100M to $200M, that doesn’t (necessarily) mean an additional $100M went into the stock. Heck, I could take some $100M companies and probably double their market cap with only $500K, through some incredibly sloppy and manipulative trading. Regarding your MSFT example, the market cap reflects the consensus of all investors of the forecast cash flow the company will generate, discounted at an appropriate rate. It might seem arbitrary, but it’s not. Intrinsic value can be tough to pin down, but it is also not arbitrary. If it gets cheap enough in an absolute sense, private capital will flow in and take the company over. They will earn extraordinary returns because of the cash flow the company produces. This fact should prevent the stock from deviating too far from intrinsic value, but oddities to happen. This is why I say again your argument is really about efficient markets and has nothing to do with the stock market creating value. Do you think the world would be a better place if we didn’t have a stock market? What sort of system would you replace it with?
bromion Wrote: ------------------------------------------------------- > Thanks for the thoughtful reply, bchadwick. > > > Now the flaw in one of the earlier posts > > (bromion’s, IIRC) is that although supply and > > demand push prices up and down, sometimes > > increased demand is driven by the fact that the > > stock represents an undervalued asset that has > > become recognized, and sometimes it’s just a > mob > > exuberance that "yay, stocks are good. Both > > processes can drive the price up, but in the > first > > case, the demand is following the increase in > > stock value, and in the latter case, demand is > > simply pushing the price around. > > This is a false dichotomy. It doesn’t really > matter why stock prices move up or down. The only > reason they do move up or down is perception that > leads to capital inflows – I buy a stock because > I believe it will be worth more in the future, at > which point I may sell it and collect the capital > gain. Whether my perception is based on solid > fundamentals or outright speculative mania is not > particularly germane. This is the crux of our disagreement. Believing that a stock is going to be worth more in the future is not the only reason to buy a stock. You buy a stock because its expected return is sufficient to justify the risk of owning it. That rate of return may include ZERO capital appreciation and be entirely due to dividend flows. And (barring accounting fraud) those dividend flows are the result of wealth creation. Buying a stock based on the idea that you will be able sell it for more later is sometimes called the “greater fool” theory, and when everyone subscribes to the greater fool theory, you do get an environment that makes the stock market look more like a ponzi scheme. > > > A simple way to see how company wealth > translates > > to an improved stock price is to use a dividend > > discount model. Assume for the moment that a > > company pays out 100% of earnings as dividends. > > The stock price reflects the present value of > that > > (approximately infinite) dividend stream. > > I agree with this, but I did stipulate in the > original post that I was excluding dividends and > commissions. Many stocks do not pay dividends, so > its hard to use this as an argument for the > aggregate stock market (although I do agree with > your logic for dividend paying stocks). Also, > whether a company pays dividends or not, new > capital is needed to cause the price to rise. The > only way prices go up is if people bid them up. > For a sustained price increase that reaches new > all-time highs to occur, a new all-time high > amount of capital must enter the stock. The market > cap is the market cap, anyway you want to cut it. No, you don’t need new capital to have an individual stock rise. You can reallocate capital by selling from a stock that doesn’t rise and has a lower rate of return than the current stock. > > Another outcome of the a process improvement is > > that the company could lower the prices of it’s > > products to reflect the cheaper production > costs. > > In this case, company earnings would not > > necessarily improve unless the lower price > > resulted in increased demand. However, > consumers > > would then have extra money left over than is > > availabe for other uses. > > This is an economic benefit and a social benefit, > but it doesn’t directly create wealth in the stock > market. I missed that you excluded dividend paying stocks. So is your argument that investment in non-dividend-paying stocks is a zero-sum game? If a company does not pay dividends, then the book value of the equity will increase, and that means that - at a minimum - the value of a share in liquidation has gone up. The intrinsic value of this share going forward is trickier to compute and has more fuzziness to it, but that doesn’t mean that there isn’t an intrinsic value. Just because we can’t tell exactly where twilight becomes night, doesn’t mean that there isn’t such a thing as twilight or night. > > There are several ways > > they can use this new surplus wealth. They > could > > consume more I other goods, pushing up other > stock > > prices beacause those companies now have higher > > revenues. > > No. Consumption in and of itself doesn’t increase > stock prices. Higher consumption and earnings > growth influences the perception of a stock’s > value, thereby creating demand for the shares. The > increase in the share price is a second order > effect, not a primary effect. Consumption increases revenues and (assuming the company has a positive net profit margin), therefore earnings. In that case, a dividend paying company stock will be worth more than it was over the long term, regardless of perceptions. Perceptions can grossly overvalue what that worth is, but that’s a separate issue. > > They could invest it in the market, > > which would lower the cost of capital for > > companies. They could save it in a bank, which > > would in turn lend it out to support other > > potentially productive activities. > > Again, I see where you are coming from with this, > but I don’t agree. This creates a positive impact > on economic growth which is beneficial to society. > It does not directly impact share prices though > except through our *perceptions* about what it > implies for share prices. We can all agree that a > lower WACC will increase share prices, but it > doesn’t actually happen unless people bid the > shares up (i.e., the exchange doesn’t have some > proprietary formula that includes WACC and results > in increased share prices automatically without > capital inflows). This is the weakest part of my argument, but not especially necessary to the main conclusion. I’d have to think about how the lowering of the cost of capital pertains to real value creation. > > > So misvaluation and irrational exuberance does > > create some zero-sum qualities to stock > markets, > > but it is not a true zero-sum game because > there > > is an intrinsic value to stocks that does > increase > > as the result of process improvements and > wealth > > creation. > > My point is that the intrinsic value is abritrary > and that you are assigning meaning to the value > based on what you define as fundamental value and > speculative value. I’m saying it doesn’t really > matter what people are using to determine value > (if they are determining it at all); the only > thing that matters is capital flows in and out of > the stock. This is important, because if no value > is actually being created, then people who better > understand what perceptions are driving the market > (and the reality of the company / product / market > / situation in question) can profit at the expense > of other investors. Intrinsic value can be difficult to calculate, because the relevant risk premiums and the likelihood of various payments are not set in stone, but I can decide whether a company that sells for $10/share and pays me $1 this year, 1.10 next, 1.21 the next, and so on is worth more than taking that $10 and sticking it in treasury securities. If other people don’t like the stock and the price goes down to $9 or even $5, that income stream is going to look even more appetizing, even if the stock price itself has dropped. — Going back to the dividend model of a company that found a way to produce stuff more cheaply and didn’t lower its prices so that they could capture the wealth benefit for themselves, what you need to realize is that the only people who really realized the wealth increase were the people who held the stock before the improvement and were holding it until after the efficiency improvement happened. Other than that, it’s all about getting an appropriate rate of return in dividends+capital appreciation for the risk level of the company. By holding the company stock, you are exposing yourself to the gains from any process improvements that the company executes WHILE YOU ARE HOLDING THE STOCK, and this is what - over time, ties stock market gains to the wealth generating process in the economy. You also expose yourself to other risks, but the idea is that over time, efficiency improvements are broadly disseminated and whoever owns the companies who develop them get first dibs on the wealth created. This is also why the time horizon is important. If you are a trader, these things tend to be zero sum, because the true wealth creation process is probably a very small percentage of daily price variation. If you have long time horizons, you start to capture these benefits more and more, and the daily fluctuations in price start to get discounted as “noise.” It is true that in times like these, perceptions can influence fundamentals and vice versa - something George Soros calls “reflexivity,” and something I also agree with. This makes intrinsic valuation extremely difficult to do in times like the present, but again, that doesn’t mean it isn’t useful in more “normal” environments.
NakedPuts Wrote: ------------------------------------------------------- > I’m not sure you understand how the stock market > works. If the market cap of a company goes from > $100M to $200M, that doesn’t (necessarily) mean an > additional $100M went into the stock. Heck, I > could take some $100M companies and probably > double their market cap with only $500K, through > some incredibly sloppy and manipulative trading. I was assuming a relatively manipulation free scenario in a stock of decent size. A penny stock could be manipulated, that’s true. As for the market cap comment, the price is based on consensus perception about the value of a stock, which creates the market cap when multipled by shares out. This seems hard to manipulate in most scenarios. Excluding penny stock manipulation, is there a way to increase the market cap to X without an additional inflow of capital equal to the delta in value? If there is, I am not aware of it. > Regarding your MSFT example, the market cap > reflects the consensus of all investors of the > forecast cash flow the company will generate, > discounted at an appropriate rate. It might seem > arbitrary, but it’s not. I disagree with this. I read a lot of sell-side reports, and the analyst are frequently wrong (more often than not). There are agreed upon methods for determing value, but the assumptions that go into that determination are frequently wrong when compared to reality in hindsight. For example, the Street is obsessed with short-term performance, which necessarily means that it is focused on cylical concerns. There are many examples in today’s market where secular problems far outweigh any cyclical pressure a company might be facing, yet the Street doesn’t acknowledge this at all. Thus, the cash flow estimates are arbitrary in a lot of cases. I’m not going to name specific tickers, but the fund manager I work for has bought several stocks that have turned into 3 to 5 baggers in the last six months alone (that’s a mind blowing annualized rate of return). These were relatively low risk investments that were priced according to arbitrary assumptions driven by cyclical concerns. The market is not efficient in small and mid cap stocks (I’m not talking about penny stocks). Intrinsic value can be > tough to pin down, but it is also not arbitrary. > If it gets cheap enough in an absolute sense, > private capital will flow in and take the company > over. They will earn extraordinary returns > because of the cash flow the company produces. > This fact should prevent the stock from deviating > too far from intrinsic value, but oddities to > happen. This is why I say again your argument is > really about efficient markets and has nothing to > do with the stock market creating value. I don’t agree with this. “Efficiency” is based on consensus opinion, which, for the most part is driven by publishing analysts focused on short-term results. But that’s beside the point. I don’t see how efficiency has anything to do with the stock market creating value. Even if the market were 100% efficient (as the people at UofC seem to think), then the market would presumably still create some amount of value (say, at the level of GDP growth, for example) if it did in fact create any value at all (which no one here has proven is the case, thus far). Maybe I don’t understand your point: How does efficiency relate to value creation? Also, how arbitrary were some of the cash flow assumptions LBO firms made during the bubble? How many of those investments are earning extraordinary returns now? Few, I would guess (and it’s hard to imagine how they ever will given the prices paid for those investments, which were at levels we probably won’t see for a long time). > Do you think the world would be a better place if > we didn’t have a stock market? What sort of > system would you replace it with? I’m not arguing for or against the stock market. It is what it is. But since you asked, I think the answer is that we would be much worse off without a stock market, since the primary market serves as a vital conduit of capital into new and (hopefully) productive ventures, which tends to be a good thing for everyone involved. But that’s the primary market, which is not what this discussion has been about. Anyway, I think I am done with this thread. No one here has convinced me that it’s not a zero sum game where no wealth is created. I couldn’t find anything else on the internet that convinced me, either, so I guess I will continue to believe it’s zero sum until I come across some convincing evidence otherwise. Ultimately, I guess it doesn’t really matter in practical terms since a forced reconciliation seems unlikely (I don’t expect the market to go to zero any time soon).
This thread is funny. I don’t know what else to add to what others have said. When you buy a share of a company you are buying a little piece of that company’s future profits. On average they will increase in the future, hence the market grows over time. How can it be a zero sum game if on average the market increases in value over time? If the market was a zero sum game by definition its total value would never increase or decrease. The S&P500 would still be valued at 100 or whatever it was when the index was first launched. I don’t understand what you are not seeing here Bromion. To me you are overthinking it so much you cannot see the wood for the trees.
Carson Wrote: ------------------------------------------------------- > How can it be a zero sum game if on average the > market increases in value over time? If the market > was a zero sum game by definition its total value > would never increase or decrease. The S&P500 would > still be valued at 100 or whatever it was when the > index was first launched. > > I don’t understand what you are not seeing here > Bromion. To me you are overthinking it so much you > cannot see the wood for the trees. His point is that increases in value don’t occur without capital inflows into the market. The S&P 500 can both increase in value over time and be a zero sum game if more capital is flowing into the market than flowing out of it. This could occur through foreign investments for example. Correct me if I’m wrong, but if the total capital currently invested in S&P 500 companies were to remain fixed (and assuming no dividend payments or stock buybacks) then shouldnt the value of the S&P 500 index also remain fixed into perpetuity regardless of innovation or improvments in technology?
given finite resources, finite timeframe and a system with finite boundaries, everything is a zero-sum game on some scale. so i think there is no absolute answer to the question, but rather it depends on how restrictive your definition of the “stock market” is
Dermot81 - that’s where you’re wrong. Those capital inflows are invested in projects that yield higher returns than the cost of capital (on average in the long run) hence the book value of the market increases over time. As the underlying or intrinsic value of a stock increases, so too must its share price (again, in the long run). If there were no fresh injections of capital into all the companies that currently constitute the S&P500, the index’s value would still increase over time as the profits generated from the current stock of capital are reinvested in further profitable projects. This is not a zero sume game. In the long run, we are all winners (on average).
Fees mean it is not a zero sum game. Both sides of a transaction pay.
had it been a zero sum game, people would have become millionaire in the last one and a half years
Of course not. Firstly, you forget about transaction costs. Secondly, on the stock market, when someone wins, it’s not always the case that some other party loses. It would’ve been the case, if the total amount of money in the market was limited, but given (especially during the uptrend) new monies just keep coming, you may buy, then sell at a profit to some other participant who only joins the market with new monies, and he will likely also make a profit later on.
firstly, the value of a stock IS the value of future cash flows and ultimately future dividends. even if you are a start-up from silicon valley, you value is basically what MSFT is going to get out of you in 10 years for example and in turn, the incremental dividends that MSFT shareholders will receive because of purchasing that start-up. name one very mature company that does not pay dividends… all immature companies will die or become a mature company or part of a mature company one day… and its earnings will end up being distributed through dividends. the reason why small and mid-caps don’t seem like they trade efficiently is because the estimates people use for 1) timing of acquisition, 2) timing of earnings ramp-up, and 3) probability of bankruptcy are all different and each input can drastically change the intrinsic value of the stock. in the end, the average of their values will be realized through dividends. cyclicality effects these 3 inputs in crazy ways. firstly, the acquirers have less flexibility and less cash to buy these guys, so the timing of acquisition is stretched out 2-10x longer than it was a year ago. secondly, with little access to capital and a tough economic environment, the earnings ramp-up is often delayed in the same manner and so when the acquision comes, the price tag will be lower as the acquirer assumes more risk. and finally, as access to capital is limited, the probability of bankruptcy skyrockets. combine these 3 factors and you get a small cap stock going from $10 to $0.20 and it is fully justified and reflects the intrinsic value for the time.