The Only Two Sources Of Money in the Stock Market
All the money that ever has been made or ever will be made "in the stock
market" can be divided into just two sources.
- Money made from other investors
- Money made from the profits of serving the customers of businesses that
trade in the Stock Market
In many ways the above fact is obvious. Yet it may also be somewhat
surprising to many investors who have never really stopped to think about it. In
any advent, it is worth considering the implications of the above fact.
Many investors could be forgiven if they thought that all the money to be
made in the stock market must come from other investors. Most of the attention
on the stock market focuses on making quick money by buying and selling at the
right time. In fact making money from other investors is definitely one of the
key purposes of the stock market.
However corporations do not primarily exist for the purpose of investors to
make bets against one another. Corporations exist to make money from their
customers. (There are rare exceptions where a company is set up for the purpose
of robbing money from investors, but that is a rare and presumably illegal
exception.) Even corporations with really stupid ideas that will probably
never make money at least hope to make money from customers at some
point.
The essence of the stock market is that stocks are valued at the present
value of the expected future cash flows that the corporation will ultimately
provide to investors. At any given time there is wide divergence of opinion as
to what this value is. The stock price is set by the intersection of the lowest
value perceived by a current stock owner and the highest value perceived by a
willing stock purchaser. This value can change radically as opinions change even
if nothing about the company changes. But the company itself is constantly
changing, which affects its value. And interest rates or returns on competing
investments are constantly changing. The result is that the market value of any
company on the stock market is constantly changing. In essence investors are
constantly trying to outsmart each other and buy stocks that they expect will
rise in price to provide an above average return and sell those that they expect
will falling or be stagnant in price resulting in a below market return.
For every stock trade, one investor will be proven correct and the other will
be proven wrong. The apparent winner of each trade may change many times
depending on the time frame. Perhaps after 1 week the seller looks like the
winner as the stock sinks. But perhaps after 5 years the buyer is the winner
because the stock is not only up but has returned an above market rate of
return.
As the market makes its determinations of the value of each stock, that value
is based on future profits from customers. If there will never be any profits
from customers then the true value of the corporation is the salvage value of
selling off its assets and paying off its creditors.
If we look at the sum total of all the money that is made from other
investors, it is immediately clear that for the total population of investors
this amount must be zero (before trading costs) since all the gains are offset
by someone else's losses. In fact the true grand total of all the money made
from other investors across the total population of investors is far less than
zero when one considers trading costs.
The inescapable conclusion then is that all the Money that ultimately will
ever be made in the stock market must come from the profits of serving the
customers of the businesses that trade in the market.
(To a socialist this means the profits are made "on the backs of customers"
but to a capitalist like myself, profits are the legitimate wages of investment.
As an aside, clearly none of the money is made "on the backs of the workers"
since workers draw money out, they don't put money in.)
Having hopefully brought to your attention that stock trading is a negative
sum game while stock owning is a positive sum game, perhaps I could stop here
and simply allow you to ponder for yourself the implications. However, I do
offer below my own view of the implications.
IMPLICATIONS
There are important implications of the above facts for investors.
If you want to try and make money by buying the stock of a company that is
not currently making profits and which will likely never make money, then
virtually your only hope is that you can outsmart another investor and sell your
stock to a "greater fool". In this type of dog company, time is your enemy. You
only want to hang around long enough to make some money, ultimately you want to
sell before the market realizes the company is pretty much worthless.
If you want to make money in a company that is already making attractive
profits and that is expected to continue to do so indefinitely, then as long as
you have not paid too high a price for the stock, all you have to do is wait.
Here, time is your friend.
It seems to me that it would be easier for most investors to make money by
restricting their investments to currently profitable or soon to be profitable
companies. If they are wrong and they pay too much then maybe they will make
somewhat below the market rate of return. And if they are right they will make a
market rate of return or higher. These investors will make or lose some money
from other investors but in general the river of cash that is coming in from the
profits on customers will insure that these investors always make a positive
return in the long run. However some amount of trading will likely be
needed in order to move out of a company if it becomes apparent that it will no
longer be attractively profitable or if its stock price has simply been bid up
far too high. In this strategy investors attempt to make most of their money
from customers while attempting to at least not lose money to other traders.
In contrast those who invest in dog companies can only hope to make
money from other investors. Meanwhile the losses of these companies is like a
current heading to the sewer.
Of course it is inescapably true that some very astute trades can make great
fortunes. Just because trading is a negative sum game does not mean that all
traders will lose. However, if you are going to be a frequent trader you should
first be able to convince yourself that there is good reason that you can expect
to win a t a game where the average player loses.
In conclusion, investors should invest in profitable or soon to be profitable
companies rather than in loser dog companies. Such buy and hold strategies are
often derided by traders. But buy and hold investors who invest in attractively
profitable companies are swimming with the current. However, investors should
not be strictly buy and hold, they should be prepared to sell when the price of
a profitable company gets bid up far too high or when it becomes apparent that a
once profitable company is no longer going to be attractively profitable.
Traders who bravely trade in loser dog companies are trying to make money from
other traders (greater fools) while swimming against the tide that is
headed to the sewer.
END
Shawn Allen, CFA, CMA, MBA, P.Eng.
InvestorsFriend Inc.
May 8, 2005
www.investorsfriend.com