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

[rainwalker78]

@Bobalude

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.

But in the example it doesn’t sum to zero. The stock is growing by 10 dollars a year. Person A Purchases the stock for 10. It is now worth 20. Subtract out the transaction and that leaves 10 of generated wealth. Person A sells to person B for the 20. They bring 20 to the system, which is worth 20. At this point, the transactions sum to zero. However, a year later the stock is worth 30. Transactions 20, value 30, 10 of wealth generated.

In your example, you are closing the game after person z purchases. You are making it more a game of Hot Potato(e). The stock market has been around longer than I have been alive, and will likely continue to be there long after I die. It is dependent on new people entering because when I die, my kids might not want the stock, so they sell it. Your kids might want it, so they buy it. The stock market will still be there.

@Bobalude

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.

Yes.

In a ponzi scheme, each person is paying money up-stream, but not getting any value for the purchase. It is inherent in the game that someone will eventually lose money. It is not inherent to the stock market. It does happen. Someone might have an incorrect perception of the value of a company. or there could be fraud (Enron). But it is not part of the nature of the stock market.

Again, i think your confusion is based on how the price of stock is determined. If,for example, you have 100 shars of stock, each share should represent a value of 1% of the company. Say their assets = 100, then each share should be $1. Simple right? But you also have to factor in the companies reputation, future profits, supply and demand. Say after all these things, everyone thinks the stock is worth $2, and that is what it sells for.

Keep in mind that these are bery simplistic answers. I hope I am not causing more confusion.

[D_Odds]

One of the questions here is “how does a company benefit from increases in share value?”

First, companies rarely distribute 100% of the equity. They hold on to a share, and as stock price grows, so does the company’s asset base. Let’s say D_Odds Inc. released 35% ownership during its IPO @ $10/share. This is common, as it allows the company to retain a controlling stake (personally, I think it better than issuing non-voting shares, but that’s a personal opinion). Two years later, my price has risen 15%. I can release another 10% of my total ownership into the market, raising more capital with more favorable terms (this is called a secondary offering).

The stock a company retains is an asset of the company. A strong asset base can give a company better deals in financing.

Equity can also be a component of pay. The thought 10 years or so ago was that linking C-level pay with stock price would further spur the executives to increase shareholder value. That thought hasn’t gone away, but it hasn’t worked as well as some were hoping it might. It is still used extensively, but I don’t think most people view it as perfect solution they did in the past.

@Bobalude

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 don’t lose money. You trade one asset for another. There are many reasons one chooses which asset to trade for. Most commonly, expected future profits is the reason. Beyond that, you have potential volatility - the risk/return reward. Also, how does one particular asset behave vis-a-vis the rest of one’s portfolio. Does this asset tend to negatively correlate versus another? In other words, does it go up when others go down? Does it give you exposure to a section of the market to which you are underexposed? I don’t believe dividends are as important as pantom, but they certainly are a consideration.

[FRDE]

@D_Odds

One of the questions here is “how does a company benefit from increases in share value?”

First, companies rarely distribute 100% of the equity. They hold on to a share, and as stock price grows, so does the company’s asset base. Let’s say D_Odds Inc. released 35% ownership during its IPO @ $10/share. This is common, as it allows the company to retain a controlling stake (personally, I think it better than issuing non-voting shares, but that’s a personal opinion)

Yerk !

You mean ‘issued shares’
The company might issue 10 shares out of 100, but the other 90 don’t have voting power - it is just a quick alternative to a rights issue.

[D_Odds]

Thanks FRDE. Maybe I shouldn’t try to post and work simultaneously.

Issued shares, to retain control, will be held by insiders. Or the company can just strip the voting rights away (Turner Broadcasting, when it was a separate company, and WWE are two that come to mind).

[Alan_Smithee]

If I invest in pork bellies or gold or timber, I have a physical good that I could (if I wanted to, and was willing to pay for the logistics) use myself. If I invest in bonds, I have a guaranteed return–I’ve traded money now for more money in the future. Both of those things have real, immediate value.

If I buy stock, what do I have? In theory, I have a piece of the assets and future earnings of the company. But in practice, I don’t have access to either one of those. I can’t redeem my stock for a piece of the physical holding of the company or the equivalent value. (Unless the company buys back the stock.) I can’t get the marketing guys to help me sell my house. I can’t force the company to offer me any of it’s future earnings in the form of a dividend.

If I have a low- or zero-dividend stock, the only value it has is the possibility that someone else will buy it. That seems like the definition of a Ponzi scheme.

I don’t think those facts are in dispute. The only question is whether that is a bad thing. It may not be. Ponzi schemes collapse when you run out of suckers. But as long as the global economy continues to grow long-term (and there is no guarantee it won’t for as long as humankind exists) the stock market can continue to grow as well. And there are plenty of safeties involved that help ensure that it won’t collapse. And IPOs, mergers, buyouts, bankruptcies, etc. keep the market tied at least loosely to the actual value of the companies.

[Telemark]

@Alan Smithee

If I have a low- or zero-dividend stock, the only value it has is the possibility that someone else will buy it. That seems like the definition of a Ponzi scheme.

The same is true for currency. I know you’re not disputing this, it’s just that it’s a very broad definition of Ponzi scheme.

[Cheesesteak]

@Alan Smithee

If I buy stock, what do I have? In theory, I have a piece of the assets and future earnings of the company. But in practice, I don’t have access to either one of those. I can’t redeem my stock for a piece of the physical holding of the company or the equivalent value. (Unless the company buys back the stock.) I can’t get the marketing guys to help me sell my house. I can’t force the company to offer me any of it’s future earnings in the form of a dividend.

Your grandfather dies and leaves a piece of land to you and 3 other grandchildren. You can’t sell the property on your own, or divide it up and sell it. You can’t live there. You can’t get 2 cents out of the thing without the other 3 agreeing to it. Do you still only own it in theory?

If I have a low- or zero-dividend stock, the only value it has is the possibility that someone else will buy it. That seems like the definition of a Ponzi scheme.

I hate to break it to you, but this is pretty much the way everything that has value gets valued. Whether it’s corn or gold or land or retail goods, your stuff is worth only what other people are willing to pay for it.

[D_Odds]

@Alan Smithee

If I have a low- or zero-dividend stock, the only value it has is the possibility that someone else will buy it. That seems like the definition of a Ponzi scheme.

Per Investopedia, a Ponzi scheme

A Ponzi scheme is similar to a pyramid scheme in that both are based on using new investors’ funds to pay the earlier backers.
…
For both schemes, however, eventually there isn’t enough money to go around and the schemes unravel.

The big difference is that, unlike in a Ponzi (or pyramid) scheme, the initial investors can benefit even if new money does not come in, based simply on company growth and/or income distribution. If I but 10% of Smithee Productions, Inc., and you produce three blockbusters with revenues of $250 million each, even if no one else invests, the value of my investment has grown. You will very, very, very rarely see the market capitalization of a company (stock price * # of shares outstanding) dip below the Net Assets of a company.

[Jackknifed_Juggernaut]

@Alan Smithee

If I have a low- or zero-dividend stock, the only value it has is the possibility that someone else will buy it. That seems like the definition of a Ponzi scheme.

Eventually, all successful companies pay dividends. Even if a company doesn’t pay dividends now, it’s stock value is based on the market’s perception of the future dividends that it will pay, plus the growth rate of these dividends. As these perceptions change, so do its stock price. Appropriately, the oldest and simplest way of valuing a company is the dividend discount model .

The more modern valuation approach, used by corporate finance professionals, is discounted free cash flow valuation . The idea here is that the value of the company lies in the cash that it generates that is available to be paid to shareholders. Basically, this is cash that COULD be paid out in dividends if the company chooses. The idea is that when a company chooses not to pay out the cash, it is actually re-investing it into the business to yield even greater cash flow. But eventually, dividends are expected to be paid out, and grow.

[Cryptoderk]

@Jackknifed Juggernaut

The more modern valuation approach, used by corporate finance professionals, is discounted free cash flow valuation . The idea here is that the value of the company lies in the cash that it generates that is available to be paid to shareholders. Basically, this is cash that COULD be paid out in dividends if the company chooses. The idea is that when a company chooses not to pay out the cash, it is actually re-investing it into the business to yield even greater cash flow. But eventually, dividends are expected to be paid out, and grow.

They don’t really use it very much, they just teach it in business schools.

Sorry!

[Roadfood]

@D_Odds

The big difference is that, unlike in a Ponzi (or pyramid) scheme, the initial investors can benefit even if new money does not come in, based simply on company growth and/or income distribution. If I but 10% of Smithee Productions, Inc., and you produce three blockbusters with revenues of $250 million each, even if no one else invests, the value of my investment has grown.

But the point being made, I think, is that you can only realize that increased value if you find someone else willing to pay you that increased value in exchange for your 10%. The stock market is not exactly a Ponzi, but it does certainly depend on there always being a supply of buyers.

The way I read the OP and later additions, the point is that realizing value from the stock market depends on it existing infintely, i.e. that there will always be another buyer. A sells to C sells to D sells to E . . . Sure, everyone can win as long as the chain continues. But if there ever is a last one in line, that one loses everything he put in. And, certainly, in isolated cases within the stock market, this happens all the time. When a company goes bankrupt, or even just goes downhill so far that it is essentially worthless, the last people to hold on to the stock in that company find that there are no buyers, and they lose. Right?

So, for the stock market in general, as long as we assume that it will go on “forever” (or at least beyond our own lifetimes), everyone can win. But if it ever does “end”, those left holding the last stocks will certainly lose.

[Cheesesteak]

@Roadfood

But the point being made, I think, is that you can only realize that increased value if you find someone else willing to pay you that increased value in exchange for your 10%. The stock market is not exactly a Ponzi, but it does certainly depend on there always being a supply of buyers.

This is technically true, but it’s true of every investment. Investments, by their very nature, involve trading your money for something, on the expectation that you will get money for it at a later date. You are always depending on someone else to give you money at a later date. Every investment risks having that someone not come through.

[gonzomax]

HuffPost - Breaking News, U.S. and World News | HuffPost It is an uneven playground for the insiders. For them it is much less a gamble than it is for you. This is only the latest episode of an ongoing program to loot the market .

[FRDE]

@gonzomax

HuffPost - Breaking News, U.S. and World News | HuffPost It is an uneven playground for the insiders. For them it is much less a gamble than it is for you. This is only the latest episode of an ongoing program to loot the market .

A $15 million fraud - total peanuts

Actually the thing that interests me is how a company can be chugging along quite happily, then a few profit warnings and wallop, it is snapped up.

And those ‘friendly’ takeovers - like Vodaphone - Mannesman

• hard to prove anything, but watching the bucks …

[China_Guy]

The underlying equity stock market is not a zero sum game. Just like this week when the markets got spanked, it was not because there were more sellers than buyers. For every seller, there was exactly one buyer. However, the price where the transactions took place was lower than it was a week ago.

Please note: Equity based derivative products such as futures, forwards, options, etc are a zero sum game. buyer and seller wins or looses depending on the underlying stock or index price.

[D_Odds]

@China Guy

Please note: Equity based derivative products such as futures, forwards, options, etc are a zero sum game. buyer and seller wins or looses depending on the underlying stock or index price.

I touched upon this in my first post. Equity derivative contracts, if used for speculative purposes, are a zero sum game. However, when used for hedging purposes, both parties may end up benefiting.

Many individual investors think in terms of only a few stocks. Professional money managers think in terms of their overall portfolio - and that might include incurring a small loss on an option contract to lock in gains on the underlying equity. This also has the advantage of lowering taxable income and overall portfolio risk.

[rainwalker78]

@Roadfood

But the point being made, I think, is that you can only realize that increased value if you find someone else willing to pay you that increased value in exchange for your 10%. The stock market is not exactly a Ponzi, but it does certainly depend on there always being a supply of buyers.

The way I read the OP and later additions, the point is that realizing value from the stock market depends on it existing infintely, i.e. that there will always be another buyer. A sells to C sells to D sells to E . . . Sure, everyone can win as long as the chain continues. But if there ever is a last one in line, that one loses everything he put in. And, certainly, in isolated cases within the stock market, this happens all the time. When a company goes bankrupt, or even just goes downhill so far that it is essentially worthless, the last people to hold on to the stock in that company find that there are no buyers, and they lose. Right?

So, for the stock market in general, as long as we assume that it will go on “forever” (or at least beyond our own lifetimes), everyone can win. But if it ever does “end”, those left holding the last stocks will certainly lose.

True, but this is true of the entire economy. The farmer depends on a food distributer buying the food. The food distributer depends on a grocery store buying the food. The grocery store depends on Joe Seedler and the rest of the population buying food. Joe Seedler depends on the farmer to buy his seeds, stc. etc. THe stock market is affected by supply and demand, just like actual goods. It depends on Buyers and Sellers, just like the rest of the economy. And just like in the example above, there can be a winner in each transaction in a chain of transactions.

[Alan_Smithee]

But the difference is that the farmer’s crops eventually get passed on to consumers who actually use them. The economy isn’t just a huge Monopoly game: it serves to deliver goods and services to people who want to use those goods and services. It is the desire of consumers to actually have those goods and services that drives the economy and gives it value.

But some things are exceptions to that rule–they are never used or consumed, only traded. I can think of only three such items: currency, large quantities of precious metals, and stocks.

Currency, as Telemark pointed out, has no intrinsic value. It exists as a medium of exchange and a store of wealth. No one (except a few collectors) cares about the slips of paper with engravings of presidents on them. It is worth noting, however, that the value of currency is transparent–that is, everyone understands that currency is useful only in the context of trade, and has no intrinsic value. Furthermore, the value of currency is functional: we all benefit from having a currency-based economy. Currency therefore has a real value which is intrinsic to the system of currency, even though the instruments themselves have no intrinsic value. (We would all be willing to pay for the services that a currency system provides if currency did not already exist.) Finally, currency in the current system is regulated by the government such that the amount of currency available is tied to the actual value of goods and services in the economy. If the government simply printed money willy-nilly (as some have done) then it would indeed be a giant Ponzi scheme, and most people would lose.

Gold and silver have practical uses, but bullion exists only as a store of wealth. In a barter economy, only makers of jewelry and electronics would value gold except as a substitute currency.

And then there are stocks. I suppose you could argue that stocks function as a sort of partial currency much like precious metals, but their value is less transparent, and their functionality is fairly limited. So long as companies pay dividends, they have an intrinsic value equal to the discounted value of those future payments. But if a company never pays dividends as a matter of policy, it is hard to see what function the stock serves or what real value they represent. Certainly, they have some value in terms of control over the company and the potential for liquidation, but those values are tiny compared to typical market value. In the absence of dividends, it is hard to see what exactly you are investing in. Why are stocks valued in the secondary market when they don’t pay dividends? It is easy to simply state that they are valued, and hence have value, but why are they valued? Everything else in the economy has some real value, whether as a good or service with intrinsic value, as a medium of exchange, or as a store of wealth. But stocks have a value in addition to any of these, and no one seems able to say what that value represents.

[Voyager]

@Alan Smithee

And then there are stocks. I suppose you could argue that stocks function as a sort of partial currency much like precious metals, but their value is less transparent, and their functionality is fairly limited. So long as companies pay dividends, they have an intrinsic value equal to the discounted value of those future payments. But if a company never pays dividends as a matter of policy, it is hard to see what function the stock serves or what real value they represent. Certainly, they have some value in terms of control over the company and the potential for liquidation, but those values are tiny compared to typical market value. In the absence of dividends, it is hard to see what exactly you are investing in. Why are stocks valued in the secondary market when they don’t pay dividends? It is easy to simply state that they are valued, and hence have value, but why are they valued? Everything else in the economy has some real value, whether as a good or service with intrinsic value, as a medium of exchange, or as a store of wealth. But stocks have a value in addition to any of these, and no one seems able to say what that value represents.

Under your model, why would anyone ever take a company private? When they do, it is clearly because either they think that profit from the company will make the investment useful, or that they can increase the intrinsic value of the company to be able to sell it later at a profit.

The value of a stock represents the consensus view of the value of the company. Consider the example of someone paying $5 for a stock that was going for $4.50. As noted, that person thinks $5 is justified. Now two things can happen. The rest of the market can examine the stock and company, decide that this person is right, and maintain the price at $5. (Or go higher.) Or, they can examine the value, decide that it isn’t worth $5, and unload their shares at this excessive price, if they can find those who do think it is worth it. If the consensus is that the stock is actually worth $4.50, its price will retreat back there. Not every trade is rational, but the sum of trades is - eventually - discounting bubbles etc.

[pantom]

I can maybe answer this with an example. That I made a metric crapload on this example is, of course, merely a side issue. (What, you think I’m going to go on about one of my losers? Honestly.)
First off, like I said above, I agree that if you’re not investing for dividends, you’re not investing. You’re speculating. I am not above a bit of speculation myself, but I don’t fool myself about what I’m doing when I do engage in this pursuit, nor do I think I’m going to do better than most. I know I’m having fun, and I know I’m probably going to get creamed for it. Some go to Vegas; some trade to get their jollies. Whatever.
But a few years ago I bought Equity Office, knowing that it was borrowing to pay its dividends. Sure enough, about six months after I bought, it cut that dividend. The price went down, but I didn’t sell.
Reason why was twofold:

1. I figured commercial properties would come back as the economy did better, and
2. Sam Zell. No one ever went to the poorhouse by following what he did.

Sure enough, from that point until about a month ago, when Blackstone took it private, the stock just about doubled, and was up about 80% from where I bought it, before figuring in those reduced dividends.
The intangible value of Sam Zell and the very tangible value of the office buildings that Equity Office owned made up for the reduced dividend. So, while dividends are important, asset value is too. And that’s what comes to the surface when someone wants to buy the company, either for its underlying assets, or for the operations of the company itself, or both.