Is the stock market a giant zero-sum game/giant pyramid (ponzi) scheme?

Great Debates
1

First I want to clarify something, is the company’s actual worth (physical assets minus liabilities) technically related to the stock price post-IPO? or any way technically related to the IPO price? When I say technical, I mean for example, does a company with total assets of $1000 going public at 100 shares (say 10 shares for the public) have to offer the 10 IPO shares at $10 each ($1000/100 shares), or can they offer it say at $12/share?

^^^
That’s something I’m not entirely clear on yet.

And the main topic. Keeping things simple, and ignoring the trade spread, broker commissions, 2nd share offerings, equity derivatives, and most importantly dividends, etc:

  1. Is the stock market a giant zero-sum game among post-IPO shareholders?

I have trouble seeing where wealth is created (ignore dividends) in the majority of stock pricing aside from an influx of more investors bringing more investment capital.

  1. Dividend payout percentages look much lower than capital appreciation, so where does the underlying value of a stock on the market come from (if there is one)? Is it backed by any physical assets?

  2. Can the stock market be viewed as a giant pyramid scheme (i.e. ponzi, but to a lesser degree), of course not literally but with many aspects of it?

My perception of it is that the bull returns of the recent few years, as well as the mid-late 90’s bull market was fueled by new investors drawn to the ‘great’ returns, of course they themselves entering the market was a contributing factor to increasing the value of stocks (if they were willing to buy at a higher price than an earlier investor).

2

IPOs can be set at whatever price the company wants. However, if they set it too high then they won’t get any (or enough) buyers. Assets play a part in the price of an IPO, but generally you are looking to the future. Future/Predicted worth is more important than actual worth. This is how internet companies, which had virtually no assets to speak of, raised a ton of money through IPOs.

Wealth isn’t created in the stock market, rather the stock price is a representation of the value of the company. There are more factors that go into the stock price, but that’s the jist of it. After an IPO selling/buying stock is nothing more than selling/buying a tiny piece of the company’s ownership.

It’s more than physical assets. It’s the whole money making operation. Let’s say that company A’s stock is worth $20 per share, and their physical assets are worth $10 per share. That extra $10 comes from the know how and/or structure in place to utilize those physical assets to make money. If the stock price becomes less than the value of physical assets per stock share, then it would make sense to sell off all the assets and return that money to the stockholders.

For example, if I somehow gained ownership of all of Apple’s physical assets but without any of the employees the value of the company would drop drastically. Why? Because there is no design team churning out new iPod designs, no logistics people to manage productions, and no one who knows how the business works.

No, pyramid schemes rely on many losers to fund few winners. In the stock market everyone can win. Some stocks (namely internet stocks) were essentially pyramid schemes, but that was more a special circumstance than an inherent property of the stock market.

3

My understanding is that the share price of a company is theoretically based on two things

  1. The underlying value of the assets the company holds
  2. The earnings potential of the company - which reflects in the potential dividends and / or future capital appreciation

Of course both of these will change over time, hence changes in share price. This presupposes of course that people are entirely rational - which is not always the case. Sometimes share price is determined purely by sentiment or emotion. Which is why share price may drop if a PR blunder is made.

4

Zero-sum in what sense?

There are many ways to value a company, but essentially a stock represents what people think the total future value of that company will be at that point in time. It’s not just the physical assets, it’s the present value of all future cash flows generated by the company and non-tangible factors like the companies brand name and reputation.

Dividends are simply profits generated by the company that are paid to the owners (IOW, the shareholders).

No, not as I understand the definition of a pyramid scheme. It’s simply a market that allows you to buy and sell companies a tiny piece at a time.

Yes and no. The stock market fluctuates anyway due to economic factors. Irrational exhuberance or pessimism can furthur drive stock prices up or down like we saw during the mid-90s tech bubble.

The act of buying and selling stocks affects the market and investment firms account for this when they buy or sell in large numbers.

5

Theoretically, stock prices are not based on current assets but on future growth discounted into current dollars.

No, it is not. A company is expected to experience growth year-over-year. Not every company does, of course, but the better ones can sustain long-term growth. Also, my gains don’t necessarily equal your losses (unless we are talking option trading, but that’s another story and not all option contracts are written expressly for capital gains).

Answered above. Actual assets do count - they are a sign of a company’s health and long-term prospects. As for dividends, they are down. More healthy companies are choosing to reinvest in themselves rather than distribute profits. It also makes it easier in lean times - many institutional investors and analysts take a dim view of cutting dividend rates, even when a company is losing money. Thus, a low or non-existent dividend helps prevent sending the wrong signal to the market.

That’s an incorrect perception. Money has entered the market - that is true. People have had to realign their thinking regarding long-term retirement and financial planning. The difference between 2-5% in a savings account versus 6-8% in the market over long periods is huge. The problem is that one must ride out the market fluctuations, and must more prudently plan - previously, pension plans did this work for people.

Make no mistake - there quite a herd mentality to the market. When the music stops playing, no one wants to be the one without a chair. * There’s also a lot of speculation, bad and/or self-serving advice, and just piss-poor investing discipline. None of this makes the market zero sum or ponzi in nature. Far more people win than lose in the market.

*An example for this was the portfolio managers I was working for back in the mid-to-late 1990s. These guys where technical investors, but they had to invest in the internet companies because the competition was, and investors would chase the returns. They hated just about every dot-com out there, but they were boosting returns, and when investors use Morningstar or Lipper to weed out poor performers, there’s no footnote saying “Sure, this manager was in the third quartile, but he didn’t invest in dot-coms.” All it shows is that the manager is underperforming his peers. Thus, once a few start running, they all start running.

6

:confused: Surely precisely as many people win as lose? I’m just talking of the secondary market here.

A trade takes place. The stock goes up. Whoever bought that stock wins. Whoever sold it loses.

What am I missing?

7

You’re missing the fact that value is created by the companies making up the stock market. Iron ore is mined, steel is fabricated, and cars are assembled, creating value. That value inures to the benefit of everyone that owns stock. Everyone can win.
In your example, you missed the fact that the seller of a share of stock doesn’t lose - to the contrary, he or she may have made a bundle, and be realizing large gains on the sale. The fact that there were more gains to be made doesn’t take away the gains already made.

8

This is only true if you think of the stock market as a gambling site or a competition. I don’t compete with anyone when I invest, I’m buying interest in companies that will grow in value over time, so that I have more money in the future. Maybe the options markets are a bit more of a gamble, but straight ownership doesn’t need to be.

I always pull back a bit when thinking about the stock market and pretend I own 25% of a little corporation. The company can either pay me every year from the profits or reinvest in the company, making the value of my 25% greater year after year. I can either keep my share or sell it to another investor. If I decide to sell and put my money in something else, do I consider myself a “loser” if the business grows? Is the value of my 25% a market fiction or does owning a portion of a successful business have inherent value?

9

Well perhaps not a competition, but certainly a gambling site.

Let me put it this way: when I buy a stock, I do so because I want to be able to sell it later for more money. Either my investment will fulfill that function, or it will not.

I’m still only thinking about the secondary market here btw. I can well understand that if I buy a stock in an IPO, I’m giving the company money that they can use to grow their business, and provide whatever goods or services they provide. But in the secondary market that doesn’t happen. I’m merely paying someone else for what seems to me, to be nothing more substantial than voting rights in an AGM.

Don’t get me wrong, I perfectly understand that some people seek to buy stocks for exactly that reason. But I think most don’t. Most people buy stocks to make money.

I guess I’m not explaining my confusion here very well. I don’t feel you or shelbo resolved my concerns, even though you gave detailed answers. :frowning:
Urgh, OK let me try to articulate better: a stock price is currently $4.50. That means that the last successful trade occurred at the price of $4.50 per share.

Does it actually mean anything else at all in terms of the underlying company? It means people are willing to pay $4.50… but… so what? If someone else comes along prepared to pay $5, how does that affect what the company is doing?

10

Why did the person who sold it lose? He found some other place to put his money. Maybe he spent it on cocaine and hookers. Maybe he invested it in the next Google. Either way, he traded it for something he valued more. He only loses if he invested in the next dud. But that’s what the market is all about-- separating the wheat from the chaff.

11

Person A buys stock at $10. A year later they sell it to person B for $20. A year later they sell it to person C for $25. A year later the stock is worth $30.

Who lost? Person A made a profit. Person B made a profit. Person C would make a profit if they sold it. There doesn’t HAVE to be a loser. Sure, if the price fell to $5, and person C sold it after the drop, you could count person C as a loser, but that is not inherent in any of the transactions. There is no reason based on these transactions for any of the participants to be a winer or a loser. The stock could have continued to go up, and each would be a winner.

Nancarrow, part of the problem here is how you are definging winner and loser. You win $100 in the lottery. I win $50. By your definition, I lost, mearly becuase I didn’t win as much.

You are forgetting to ask: Why is someone prepared to pay $5?

Someone willing to pay $5 does not immediatly affect what the company is doing. But they are willng to pay $5 for a reason. They think they are getting value out of the deal. They could think this for many reasons. They might think that the value of the company will be $10 in a year.

I think part of your question is what drives the stock price. Mostly, the perception of what the company is/will be worth. Partly based on assests, partly based on the companies image, partly based on 1000 other things.

12

The OP does have a point though. The company itself gets its money and hands out shares during the IPO. After that, people are trading shares of the company among themselves like baseball cards and most of those trades have nothing to do with the company itself. The shares are perfectly free to float up and down based on nothing to do with the company and they sometimes do. The promise of dividends used to tie the shares back to the actual company but these are rare in some sectors now.

I know all of this is simplistic but it isn’t inherently wrong. Stock prices don’t necessarily have to correlate with anything to do with the company the shares have as a title. In reality, they tend to because companies can buy back their own shares among other things but it is a complex topic and a little simplistic itself to just consider a stock a piece of ownership when that concept is so abstracted.

13

Perhaps the OP should read up on Value Investing. Many people do, in fact, play the stock market like a craps table, but that isn’t how the smart money is managed. And while there are many other schools of investing besides Value Investing, that method is the most easily understood in everyday terms. It seems to have worked pretty well for Warren Buffet, btw.

14

Read books like the intelligent investor and you might get an appreciation for how companies can create value.

15

As an aside, if you’re going to try to apply some game theory to the stock market, what’s more applicable is the Pasadena game (at least in trying to determine how stocks will move).

The original Pasadena game is a ‘party’ game - at a party, everyone is supposed to guess 2/3 the average of everyone’s guesses. You end up trying to guess what other people will guess what other people will guess …
While the Nash equilibrium (what strictly rational players will play) is 0 (the sequence is infinite), the game (like the market) is better thought of using a behavior model. Most people won’t iterate more than a few times (though that doesn’t mean you’ll always know how to play the market, it’s just how things often work).

16

This is a good example of how I wanted to visualize/discuss it.

Say it goes onward and person D buys it off the hands of person C… E buys it from D, and so on until person Z purchases the stock for $60… now 26 people have changed hands of this stock.Without regard to dividends, in the secndary market for this share of stock, what backs the value of this share?

I see it as the ‘prospect’ of a future person buying the share at a higher price, as the primary reason for A, B, C … to Z to buy it. Now if you were to close up the market, and only leave the 26 original people in the system, person Z must rely on the other 25 to purchase the share in order for Z to make a profit, break even, or take a loss. Was this stock worth $60? maybe, maybe not. This is quite simplified, but in some ways it does feel like the prospect of earnings is dependent on future investors entering the market, a lighter version of a ponzi/pyramid. (again, dividends are ignored for a simplified example. See below for my thoughts on dividends)

When I mention a zero-sum, I’m thinking a zero-sum game in relation to game theory. Here people are purchasing the right to have a position as a player in the game. Zero-sum being that you lose X amount of money to purchase a share as a buyer to enter the game, and the seller gains X amount of money to exit the game. You then have the right to play the next round of the game with a future player, in hopes of selling your position for a higher amount. In the above example, each person from A-Z gained or loss an amount that leaves the overall value of the system that sums to zero, except the initial purchase by A ($ goes to issuing company) and Z who holds the right to the share until sale.

Of course dividends are a plus or interest on your position to hold it longer, but the reason I ignore them for this debate, as mention so earlier, because a LOT of volatile stocks sell for way more than dividends pay out. Companies w/ a high price/EPS ratio seem very illogical (IMO) to buy on a technical level… where the large value of capital appreciation relies on the demand of people willing to buy/sell the stock at high prices, rather than have the underlying performance guide the price.

Am i way off base to see it as a large ponzi scheme and zero-sum game? Coming from a background of econ theory and less hands on investing in the market, I am trying to rationalize the value of investing, but can’t help but often see too many things appear overvalued but yet still heavily demanded and traded.

17

In a Ponzi scheme, investors aren’t investing in anything of value though. In the stock market, you get a small piece of a corporation, which has assets and can increase in value through expansion. It’s true that stock markets bubbles are rather similar to a Ponzi scheme, but stock market bubbles are as irrational as Ponzi schemes.

18

Dividends. It’s what makes the difference.
Buy a bond, and you get 4 or 5 or 6% of the face amount for as long as you hold it or until it matures.
Buy a stock with a 3% yield, but a long history of raising it every year, and after a while you’ll be making way more than you would have with the bond.
A lot of people ignore dividends. There’s a word for them: fools. Fools and their money quickly part. It’s an efficient market, that way.

19

You guys are acting like the non-IPO market is some sad little sandbox where people with money play. It isn’t, it’s actually the reason the stock market works, and the reason IPOs succeed. Would YOU invest thousands upon thousands of dollars of your savings in an IPO if there weren’t a liquid secondary market to sell the shares in? There isn’t anything more worthless than ownership of something you can’t sell. I personally own thousands of shares of some little 3 man corporation, and can’t sell my shares to anyone, can’t affect any business decisions can’t force them to give me a dividend either. The shares are ultimately worthless because there is no secondary market for them, and I don’t ever expect there to be one.

Unless you’re talking about fraud, this is total bull. The price may change based on speculation about the company, which may or may not be accurate. Or on expectations about the company that fail to pan out. Neither of those are “nothing to do with the company” they are people trying to divine the future prospects of the company and apply that to the current price. The future is uncertain, and people will be wrong, but that doesn’t make them dissociated with reality.

Actually, it is not too simplistic at all to consider stock a piece of ownership, since that’s the exact definition of owning stock. I also fail to see how the concept is abstracted. If you can conceive of owning 25% of a small company, you can conceive of owning .00025% of a much larger company.

20

IPOs don’t really raise new capital, they might have done once, but nowadays they are just an opportunity for the venture capital providers and founders to get their money out.

The established markets are dominated by the pension funds, institutions etc, those guys are quite capable of trading with each other, (Private Placement anyone ?), Joe Public is like a minnow next to whales.

Personally I reckon that the current system is expensive, sending out bumpf and trivial cheques costs a lot of money (sure, there are nominees a/cs), and management has to tart to the public because a trivial price movement will set the major players ‘program selling’.

Under Roman Law the definition of ‘ownership’ was ‘control’ and if a bunch of minnows each owning 0.00025% add up to less than 75% then they are hosed.