Is the Stock Market a Hoax

Hello All,

This seems like a silly question, but the more I ask it, without getting an answer that seems to make any sense, the more I wonder. I’ve tried asking Cecil, but his staff’s response just doesn’t seem to answer the question.

Everything that has value has that value because someone wants to own it. For example, you were willing to pay money for a shirt because you wanted to wear it, a steak because you wanted to eat it, a book because you wanted to read it, ect. But, why would you want to own a stock? What can you do with it? I suppose you could take the actual certificate and burn it for heat, or use it for note taking, but I doubt anyone would want to do that. Now, the common response I get from friends is that people want to own stock to make money. But…how can they make money if no one wants to own the stock in the first place? For example, the store owner who sold you that shirt had to buy the shirt in the first place. And he didnt’ want to own it himself, he bought it to sell to someone, someone who turned out to be you. However, you were only willing to buy it because you wanted to own it. If the shirt was hideous looking, and he knew that no one would buy it, the store owner would never have bought it either. Same thing with real estate. I might not want to own that plot of land myself, but I buy it so that I can sell it to someone who does want to own it and build a home on it. With stocks, no one wants to own them. I buy it to sell it to someone who only wants to sell it to someone who only wants to sell it, and so on and so on. Ultimately, nobody wants it, and if nobody wants it, how can it have any value at all? Why are people paying money for something that nobody wants to own? Oh sure, there are exceptions, super rich folks who want to own enough to take over a company, or perhaps own stocks that pay dividends, but in most situations, this is not the case. The entire stock market just seems like a giant game. The money a company is making, or losing, interest rates, new products, market share…none of that matters. It’s all just one big fraud!

I own a share because I think it will be profitable to do so. I think it will be profitable because the company will pay me (as a part owner) a share of the profits. Further, I hope that I can sell my part of the company at a later date for more than I paid for it.

You could say the same thing about a $100 bill, and it would actually make more sense. The stock certificate at least represents something tangible; the $100 bill just represents 100 arbitrary units of wealth.

Buying a stock is like borrowing someone money to gamble with. They give you an I.O.U. (the stock) for your money while they gamble with it. If they make money with yours the value of the stock will go up so when you cash in your I.O.U. it’s worth more than you paid for it.
If they end up losing the money you borrowed them the stock value falls and when you cash in your I.O.U. you don’t get back the full amount you paid for it.

“So why don’t I just take my money to a casino and gamble it myself?”
Because the odds are better with stock. Casinos always have an edge so you will always lose in the long run. The stock market at least plays a little more fair.

First of all, lets talk about what stocks are. Stock represents equity in a company. Companies issue shares of stock to raise cash. In other words, if you own one share of GE or Microsoft, you are 1/XXXXXX owner of that company. You can vote on resolutions, go to shareholder meetings, and so on. It’s not much ownership so individually, your oppinion doesn’t matter much, but it’s still ownership.

Why does someone want to own stock? Well, basically you are hoping that the company you are investing in is going to grow and be successful. The more successful the company is, the higher the stock price goes.

Now it’s very difficult to pick an individual stock that’s going to grow without doing any kind of research. That’s why we have mutual funds. A mutual fund allows you to invest in a number of stocks, reducing your risk if one of them tanks.

Also, you don’t need to be super rich to own a dividend paying stock. All you need is to be able to buy one share. My former company is a little under $14 a share and pays dividends quarterly.

Of course, one hopes that the people in charge of the mutual funds have done a bit of research…

Paul in Saudi already answered your question, but I can give more detail.

Some things, like paintings are indeed only given a value because someone wants to own them. If an artist dies, his work may go up in value because there will be no more of it.

Stock however is a financial transaction. You own a piece of a company, that only exists to make profits for you and the other shareholders. The company may well invest some of its profits in the business, but the rest goes in shareholder dividends.
A company that makes high profits will attract interest. More people would like to own such a rewarding share. therefore the share price rises.
A company that makes losses will similarly suffer a drop in share price.

Perhaps you were confused by the debacle over Internet companies a few years ago. Many of these were over-valued, because although the companies had less costs (e.g. no High Street sites) and masses of potential customers, they didn’t have a good business plan.

I personally invest in a unit trust. I pay a company to buy stocks for me. I have no idea which companies they are going to buy beforehand. As long as my units keep going up in value, and paying a dividend, I’m happy.
It’s not about liking a company - it’s about profit!

This is not to contradict the previous informative answers. I’m just hoping to give another angle of looking at it.

Suppose I want to start a company. I need capital to do that; e.g., I need to buy a factory. If I can’t afford that and can’t get a loan, then I can take on a partner who can provide the funds. The partner wants to get involved because her investment is repaid by a portion of the profits my company will make. Instead of one partner, I can take on two partners, or five, or one-hundred. A corporation is a way for a business to get funding from lots of people. These people don’t have a big say in how the company is run, but they aren’t personally liable either.

When one buys a stock, my share of the profit is returned to me in the form of dividends at regular intervals. The present value of those dividends over time represent a real value, just like a shirt does: being paid $1/year in perpetuity, for illustrative purposes, can be figured to have some particular value, and this income can be used to buy goods & services.

Sometimes a firm will not pay dividends, but reinvest it instead by buying more plant & equipment, for example. I’m not going to do the math, so you’ll have to trust me that this growth policy ends up having the same net present value as the dividend stream.

Of course, actually gauging this value is all but impossible—IMO it is impossible. But the important point is that there is a value to a stock; it is not just a piece of paper.

Be aware that there are other schools of thought on how a stock is valued, and one of them bases its estimate on how much others will be willing to pay for the stock. IIRC, Keynes made quite a bit of money using this investing philosophy. Nevertheless, there is something there behind a stock that is of actual value, and that’s why one would want to get into the market.

Well, these are the responses that I generally get on this question, so let me point out why they don’t make sense, well, at least how they don’t make sense to me anyways.

Dividends: This part does make some sense, and I think I referred to them, although not by name, in my original post. If you buy a stock to get a dividend, then yes, that stock has value, namely the money that you get paid just for owning it. I question, however, how many people own stocks that pay dividends. My experience says that very few do. But, if you’re buying a stock for the dividends, or are buying a stock that provides dividends in the hope that you can sell it to someone else who wants those dividends, then yes, that stock has value. Much like buying the shirt or the land to sell to someone else who wants it.

Making Money: The idea that if the company does well, your stock goes up, and you make money. Here’s the problem. If the stock doesn’t pay dividends, then there’s absolutely no reason why the stock’s price has anything to do with the money that the company does or does not make. So what if Acme Widgets made a zillion dollars in profit last year? If they don’t pay me, as a tiny part owner, any portion of the profit, then what does it matter how much they make or lose? True, the stock might go up in value, and I could sell for a profit, but that brings me back to my question. Why would it go up in value? If I have a stock, that doesn’t pay dividends, and can only bring me money if I sell it, to someone else who can only get money from selling, to someone else, and so on, then why does anyone want to own that stock? I can’t believe it’s to be able to vote in a very tiny way on company issues. If the stock has zero value beyond selling it, no dividends are paid each year, then why does anyone in their right mind want to own it? Now, obviously people want to own it to make money, I’m not that much of a stupidfool, but my point here is that the whole system is based on nothing of value, unless you can take your stock, march down to company headquarters, and demand your share of the profit, something I don’t think too many companies will allow you to do.

People talk about analyzing a company to determine the value of its stock and whether you should buy, sell, or hold, but what you’re really analyzing isn’t the company (because again, what does it really matter how the company performs) but are instead analyzing how other people are going to respond to the company’s performance.

Surely there’s somebody out there who gets what I"m trying to say? Somebody? Anybody?

From the OP mention of shirts and steaks, it seems a concrete, easy to visualize example might help illustrate the concept.

Suppose one day you meet a guy who is selling little magic machines. Every so often, say every three months, you can open them up and coins drop out. The number of coins is not guaranteed, in fact no coins may come out. However, your buddy told you the other day about a machine he had that kept giving out more and more coins. In fact, that’s how your buddy became very wealthy.

You’d want one of these machines, right? But it turns out there are lots of different kinds of these machines (stocks) and the ones that pay out more coins end up being more expensive for obvious reasons. There’s a chance your machine gives smaller payouts than you expect, and if this happens and you decide to sell your machine, you’d probably get a lower price for it and may end up losing money in the process.

Oh, and occasionally, the machine may break (go bankrupt) and stop working entirely.

Some people don’t understand how these machines work and perhaps shy away from them entirely. Others know a lot about these machines, perhaps analyzing them for a living, and believe they know which ones have a better chance of making money. Still others will just buy a bunch of different kinds of machines (mutual fund) and put their hopes on the average performance. Depending on which kind of person you are, you might not consider these “machines” to be a fraud or a hoax and actually want to own one.

Yes, and I’ve addressed it. A company that adopts a growth policy instead of a dividend policy ends up with the same net present value on its stocks that it would have with the dividend policy. If you want to see the math, then get Brealy & Myers. In addition, you are sticking yourself into one school of understanding which has effectively put you in blinders.

But a stock that doesn’t pay dividends does have value. It is a 1/xxxxx ownership of the company. A company can pay shareholders dividends out of the company profits, or they can take that money and increase the value of the company. Say you own a 1/100 share of a company worth $100, and the company has a profit of $1. They could pay a dividend to shareholders of 1, and every shareholder would get .01. Or they could keep the money in the company (buying more equipment, advertising, or whatever), now the company is worth $101, and each share that used to be worth $1.00 is now worth $1.01.

Of course it is never that simple, the company could keep the money and increase the value of the company by more or less than $1, and measuring the value of a company is extremely imprecise, so different people can have different opinions on exactly how much a company is worth, measured by how much they would be willing to pay for 1 share of the company. The stock price as traded is simply the current equilibrium price where people who wish to sell the stock can find people who wish to buy the stock and vice versa. When more people want to sell the stock the price goes down, when more people want to buy the stock the price goes up. Simple in concept, difficult in practice.

And you thought you didn’t know how it worked!

I think your problem is that you are thinking about it too much, trying to logic through the reality, while the explanations in this thread are more textbook in nature, explaining the logic behind a theoretical market without getting into the lunacy that the market really is. Should the value of a company rise and fall through the day, especially if there is no new information as to its profit-making? Of course not. Going back to the internet boom, should an internet startup with no product, no business plan, and no likelihood of making a profit for many years have a stock market value higher than a “real” company with all of those things? Obviously not, though it happened and people lost their shirts when the balloon burst. Or my personal favorite, why would anybody invest in a stock they had no insider information on? I dunno. Sounds pretty dumb to me but I think playing video poker is a dumb way to try to make money, too.

Like Hampshire says, playing the market, versus putting your money in mutual funds because, over time, the payoff is much better than that of a savings account, is a form of gambling. It’s odd the degree that gambling influences our economy but, for the most part and in the long run the values of individual companies end up not over or under valued with too much “irrational exuberance.”

That is, I believe, the best answer I’ve ever heard.

I would wonder, though, if your company’s shares are really worth $1.01 automatically. They’d really only be worth that if someone was willing to pay that much. It’s certainly true that prices go up or down based on whether more people want to buy or more people want to sell. My question wasn’t so much about why the prices go up or down, but why anyone would buy the stock in the first place, if the company isn’t giving out dividends of course. Because, if I can’t demand money from the company for my stock, it really only has value if I can sell it.

If you are trying to say mutual funds are the safe way to invest, you have to realize the people who invest for a mutual fund don’t have any magic secret to good returns either. After fees the vast number of mutual funds do worse than the market, mainly cause they don’t have any insight that can work with huge amounts of capital, and because of the fees.

I personally like stocks that pay dividends because dividends require cash flow and not just manufactured profit, and without dividends, the value of a company and drop at any time without giving you anything. However, if a company paying dividends drops in price, the value of the dividend relative to price becomes more attractive, the dividend is almost like a buoy in that case.

In the absense of dividends though the stock market is a zero sum game. For every person who sold higher than they bought, someone had to buy at that high point.

For some growth companies that don’t pay dividends, you could make an argument that their growth will enable them to pay bigger dividends eventually.

Although The Controvert’s illustration was indeed very insightful and a useful tool that I’ll use without shame, if you think that magic machines answers the question of how we know the stock market isn’t one big hoax, then I wonder whether you have failed to understand. The analogy is exactly the dividend payment method of stock valuation, the very method of valuation you said did not answer your question.

I believe I understand what you’re saying, and I can see how the responses so far are not addressing your real question. People are doing a good job of explaining how stocks and the stock market work, but your question is more about why than how, right?

Your point is that something like a shirt or a steak has intrinsic value. That’s really what you’re saying when you say that something has value because someone wants to own it, you’re saying that it has intrinsic value. It is, in some way, useful to own, there is value to having the thing, in and of itself.

Stocks, on the other hand, have no intrinsic value. There is no usefulness to owning a stock, in and of itself. A stock share only has value because a whole bunch of people agree that it has value, and that is the key point that addresses your OP. Many previous replies have explained how that value is arrived it, but the essential point that I believe you were asking is that that “value” has no real existence. It only exists by agreement among a bunch of people.

So then, as you asked, why would people want to own them? Well, as VarlosZ so aptly pointed out, you can ask the same question about a $100 bill. It has no intrinsic value either. It only has value because a whole bunch of people have agreed that it has value.

I mean, really, when you bought that $100 shirt, the storekeeper gave it to you and took that little green rectangle of paper in exchange! You’re now wearing that great shirt, and all the storekeeper has is a scrap of paper. You sure came out ahead on that deal!

Well, no, you didn’t, because the storekeeper can go into the supermarket next door and exchange that same “worthless” scrap of paper for five big, juicy steaks. Boy, now he’s got a great meal for his family, and all that silly supermarket owner has is that dumb scrap of green paper!

Well, except that the supermarket owner can use that scrap of paper to pay one of his clerks for a day’s work. And so on and so on. As long as the agreement as to the worth of that silly scrap of paper holds, it has great value.

Stocks, really, are no different than cash or any other form of money. The value exists only by agreement amongst everyone involved.

Why do you want to have a $100 bill? Because, since everyone agrees that it has a “value”, you can exchange it for things that have “real” value.

Why would anyone want to own stocks? Because everyone agrees that they have a “value”, and because that agreed upon value changes over time. If, today, I exchange one of those silly $100 scraps of paper for an equally silly scrap of paper that says “stock share” on it, sometime later I might be able to re-exchange that “stock share” for two of those silly $100 scraps of paper!

That’s why people buy stocks. Because everyone agrees that they have value, and you hope/think/believe that the agreed upon value will increase.

But, again (just to run it into the ground), you’re right that there is no actual value there, the value exists only by agreement. If, tomorrow, everyone decided that stocks had no value and no one at all was willing to buy anyone’s stock, everyone who owned stock would have a bunch of worthless pieces of paper.

And by the same token, if, the day after tomorrow, everyone decided that currency had no value, and no one was willing to exchange their shirts or steaks for them, you’d have a bunch of worthless pieces of paper in your wallet.

Oh, heavens, no! I’m just saying that the fund managers’ lucky breaks usually outdo their unlucky breaks and that having a bunch of stocks to get lucky with improves their odds versus those of Joe Blow with only a little to invest. Note that I do not refer to skill, as the only skill I have seen to be effective is the ability to minimize one’s mistakes, like bailing out of tech stocks once everybody and his grandmother started saying, “This market is overheated and the balloon will burst soon.” Believing you know when a bubble will burst *without * inside information so you stay in so you can bail justbefore is hubris but if you are right (lucky) and will give you the reputation of being a sage. Of course, being wrong means you join the crowd of other boneheads, but everybody quickly forgets who they are.

The best way to legally make money in the stock market is the same way you make money anywhere: as the middleman. Brokers get their cuts when you buy and when you sell.