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Friday, 30 October 2009

Why do stock markets exist?

By Richard Field

When a business is started it may run for some time as a private organization. It might be a partnership, a proprietorship, or even incorporated. There are many large and small privately owned organizations in the world today. Sometimes the founders and owners of these organizations want to raise capital for expansion of their business. They would then go to a venture capitalist for an investment. Later on an Initial Public Offering (IPO) could be made in a stock market. In essence, shares of ownership in the company are being offered to the general public.

Why do people buy shares in organizations? Again, the easy answer would be to say "to make money", but that still isn't true. The primary answer is that you buy shares in a company as a way to provide your capital (money you have) for that company to use in pursuit of its objectives. You might buy shares in a hospital because you support their values of taking care of the sick. You might buy shares in a beer distillery because you enjoy their products. Now, in return for providing your money you would like some return. That might be a dividend, a payment for every share you own, let's say $.25. It's like getting interest on a loan. Or, maybe the stock appreciates in value because of underlying inflation in the economy (everything is worth more so your company and its assets are worth more too) or because the management of the company is doing well. For example, sales of beer might be so good that income is higher than expenses and there is a profit being saved or reinvested in the company.

Now it is true that people buy shares in an organization with the hope that they can sell those shares and make a profit. They might care nothing about what the organization does, what business it is in, and how it relates to its community. People who day-trade stocks would fall into this category. They buy now and sell a few minutes to a few hours later. They never expect to actually hold onto stock or become part of the company. This activity is possible given the way stock markets work, and nowadays is easy because of the Internet. But it is not why stock markets were created. The underlying reason for a stock market is to provide a place for you as an individual to invest in organizations and to divest (or sell) that investment should you change your mind.

A common misconception about the stock market is that a rise in the market, let's say of 5%, has "created wealth". This is in the newspapers and on TV all the time. When the stock market drops 5%, analysts will say that there has been a "loss of wealth". It just isn't true. To make this example more particular, analysts love looking at Bill Gates' wealth. They take the number of shares that he owns in Microsoft, and it's a large number because he co-founded the company, and multiply that number by that day's price of Microsoft stock. The answer is in the billions of dollars. Now let's say that Microsoft stock goes up $2 a share. Does that mean that Bill is that much wealthier? No it doesn't ... because Bill isn't selling! Bill Gates started Microsoft in order to provide programming for micro-computers, not to make money on the stock. Yes, it's nice to make money, and it's nice that Microsoft stock has risen, but I don't think that's the fundamental and underlying reason he and Paul Allen started the business. Or when Microsoft stock goes down $2 a share, Bill hasn't lost money either. Think of your house. Let's say it's worth $200,000 today and next year you read in the newspaper that in your neighborhood houses are worth on average $230,000. You haven't made $30,000. You still want to live in your house don't you? Yes you do, just like Bill Gates doesn't sell his shares in Microsoft because they went up $2. He still wants to own his company, to work for it, to make a difference in the world of microcomputers. You could make the $30,000 on your house if you sold, but then you'd need to buy another house and you would have the transaction costs to think about -- realtor fees, lawyer fees, and moving expenses. Two years from now house prices have dropped back to $200,000. Did you lose $30,000? No you didn't. It was all on paper! You're still in your house. Nothing has changed. It's the same with the stock market. It goes up and down but the only losses and gains are from the people who actually bought and sold. And that, compared to the total value of stock, like the total value of houses in a neighborhood, isn't a lot.

Now you would think that the price of a stock would rise when the company was doing well, when they were "making money", when income was greater than expenses. But this isn't always true. Take any one of the many dot com companies formed around the year 2000. Hardly any had more resources flowing in from sales than they had flowing out. The logic of that time, and it is still true in a few cases today, was that there was an Internet land rush going on and companies had to get out there and stake out their claims. If you wanted to claim the .com market for, let's say, selling toys over the web, then you had to spend a lot of money to buy programming staff and equipment to get your .com site up and running. You weren't expected to actually make more money than you spent. And stock prices rose as people who wanted to buy some of that .com stock bid up the price. The price rose not because of underlying fundamentals (the product or service was worth more than it cost to provide). Of course, many of these companies had a burn rate (how fast they went through money) that was so high that they spent all of their venture capital investments before they had any significant revenue stream to speak of. But they didn't actually go bankrupt until the dot com crash hit and it became difficult or impossible to get the next round of funding. The venture capitalists and the stock market simply stopped the flow of money into the organization. People who bought into the .coms were betting that there would be lots of potential in the future. The dot com crash came when it became more clear how hard it would be to realize that potential -- that the costs of doing business on the web are so high that it isn't easy to bring in more revenue than you spend.

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