What's the benefit to society of stock speculation? [edited title]

[DragonAsh]

@septimus

No need to “enforce scarcity.” A very small transaction tax, while not a panacea, would be a good step.

There already are transaction costs & taxes. How do you think exchanges make money? How do you think brokers make money? Transaction taxes are seen overseas (UK, Sweden) and the US is considering such a move as well. Obviously any gains are also taxed. Most studies have suggested that transaction taxes would result in higher price volatility and lower overall trading volume. In fact, the IMF issued a paper that suggested that such a tax could actually make it harder for markets to autocorrect against the formation of asset bubbles. Essentially, the higher costs (be it taxes or other transaction costs such as brokerage fees etc), the lower the volume, slower overall price discovery, which could mean greater price volatility, and could also make it harder for the market to correct in the case of asset bubbles.

You can read the IMF report here: Warning: PDF

Incidentally, transaction costs are considerably cheaper nowadays then the were several years ago. Not too long ago, commissions were fixed at 1% of the value of the trade. If you wanted to buy $100,000 worth of stock, you had to fork over $1,000. Also meant you had to generate at least 1% positive return just to break even.

Nowadays some online brokers offer flat rates of $7 per trade regardless of trade size. Compare that $1,000 fee vs $7. In fact, lower transaction costs is one of the main reasons day trading is now possible; 15-20 years ago day trading just wasn’t economically viable. I’m sure I don’t need to do much to convince you that everyone benefits from lower costs (well, except for the full-service brokers that relied on juicy commissions and account churning).

Three guesses as to why transaction costs have come down so much in recent years.

Now, I suppose you could construct an argument that at some point ‘more liquidity’ doesn’t add much value. Theoretically you could also probably argue that it could lead to excess volatility (with the devil’s advocate counter that in every single bubble/bust case in history, it’s only after liquidity dries up that the proverbial shit hits the proverbial fan. Granted, that’s a bit like saying that falling from the top of a building isn’t a problem, it’s the landing that’s a bit tricky).

Diminishing returns and the idea of marginal returns is a cornerstone of every economics textbook ever written, I’m not sure it’s been used in pure financial theory. It’s an interesting thought, and at some point if I have time I might give it a think.

Still, my current instinct remains that trying to reduce liquidity directly would be a bad thing - and I’d really like to see more specific concrete evidence that this ‘too much liquidity’ concept actually is a concern. More prudent, I suspect, would be to attack the potential problems not from the supply side but from the demand side: in other words, make it harder to over-leverage. Higher capital requirements, for example. Greater disclosure. Greater standardization of contracts for off-exchange products (non-standardized CDS contracts was one of the major problems from the subprime crisis, as JohnT pointed out. They are starting to correct this now; I believe CDS premiums are now fixed at one of two bands?).

[off topic]
One of the problems with the infamous CDS (credit default swaps) was - here’s that word again - over-leveraging. CDS are like insurance: if a bond defaults, the seller of the CDS agrees to pay to the buyer the face value of the loan. Originally, bond holders buy CDS as ‘insurance’ against the bond they held. One of the problems, however, was that you didn’t need to actually own the bond to buy the CDS ‘insurance’.

If you own a house, you buy insurance on it, but you normally wouldn’t buy insurance on someone else’s house. This is what was happening with CDS, however: many many people could buy this default insurance on bonds they didn’t own. So a $1 million bond could force a payout of $10 million if it went bust.

Of course, during good times defaults are rare, particularly for highly rated bonds - so the companies selling CDS (AIG was a major seller) were more than happy to take the premiums. As far as they were concerned it was risk-less money in the bank, and for years that was the case - several dozen people are rumored to have made millions buy realizing the subprime crisis was around the corner and buying CDS, but they had to pay thousands (if not millions) of dollars in premiums while waiting for the eventual crash…[/OT]

[yelimS]

The Guardian had a very unflattering article yesterday:

@George Monbiot

The findings of the psychologist Daniel Kahneman, winner of a Nobel economics prize, are devastating to the beliefs that financial high-fliers entertain about themselves. He discovered that their apparent success is a cognitive illusion. For example, he studied the results achieved by 25 wealth advisers across eight years. He found that the consistency of their performance was zero. “The results resembled what you would expect from a dice-rolling contest, not a game of skill.” Those who received the biggest bonuses had simply got lucky… Chief executives now behave like dukes, extracting from their financial estates sums out of all proportion to the work they do or the value they generate, sums that sometimes exhaust the businesses they parasitise… The very rich are often described as wealth creators. But they have preyed on the earth’s natural wealth and their workers’ labour and creativity, impoverishing both people and planet. Now they have almost bankrupted us.

Granted, it’s about finance in general, rather than just stock speculation, but it seems to apply.

[septimus]

@DragonAsh

You can read the IMF report here: Warning: PDF

I’d really like to see more specific concrete evidence that this ‘too much liquidity’ concept actually is a concern. More prudent, I suspect, would be to attack the potential problems not from the supply side but from the demand side: in other words, make it harder to over-leverage. Higher capital requirements, for example. Greater disclosure. Greater standardization of contracts for off-exchange products (non-standardized CDS contracts was one of the major problems from the subprime crisis, as JohnT pointed out. They are starting to correct this now; I believe CDS premiums are now fixed at one of two bands?).

One of the problems with the infamous CDS (credit default swaps) was - here’s that word again - over-leveraging.

I downloaded the pdf and will read when i have time … but I wonder if it’s similar to one I read a year ago after a cite in a similar thread; that one, IIRC, found fault with a small transaction tax, whereas I advocate a very small transaction tax.

I didn’t mean to speak of “too much liquidity,” except in the sense that diminishing benefits can be outweighed by increased risks. I consider the high stock exchange volumes (much of it from day traders or “millisecond traders”), excessive use of derivatives (most of the credit swaps, IIRC, were plain gambles unrelated to actual direct hedging), and overleveraging (for which “Heads we win, tails taxpayer loses” banking may be prerequisite) to form a flawed approach I call “hyper-efficiency”; they serve public interest minimally, while running systemic risks. The exact systemic risks may become clear only in hindsight … but some such risks can now be seen in the rear-view mirror.

[CutterJohn]

@DragonAsh

The only way the primary market works (i.e., the market when the stock/bond etc is first created and sold) is if there is an active, liquid secondary market. No one would buy an IPO stock if they thought they’d never be able to sell it. Guess what happens if no one wants to buy an IPO stock?

Pretty sure the bond market would function, wouldn’t it? Those are just loans. I suppose they can be resold, but there wouldn’t be a requirement to do so to get any of your money back. You’d wait for it to mature and sell it back to the company that issued it.

[DragonAsh]

@CutterJohn

Pretty sure the bond market would function, wouldn’t it? Those are just loans. I suppose they can be resold, but there wouldn’t be a requirement to do so to get any of your money back. You’d wait for it to mature and sell it back to the company that issued it.

No - why would it be any difference? A bond pays interest. A stock (usually) pays dividends. Either way, it is pretty rare for a bond holder to actually hold a bond to maturity.

But even if they were willing to at first, they’d be unwilling to purchase a bond if rates moved significantly against them. Suppose you bought a bond that pays 5%. Then interest rates start rising - which means the price of your bond starts falling. Let’s say rates rise to 10%

Sure, you could just sit on your 5%…but wouldn’t you rather have your money in something that was generating 10%? Can’t do that if you can’t sell your bond.

Granted, this is over-simplifying things, but that’s the general idea.

[Trom]

@CutterJohn

Pretty sure the bond market would function, wouldn’t it? Those are just loans. I suppose they can be resold, but there wouldn’t be a requirement to do so to get any of your money back. You’d wait for it to mature and sell it back to the company that issued it.

The amount of money that changes hands in the secondary bond markets daily makes the entire stock market look like a drop in the bucket.

[Damuri_Ajashi]

@yelimS

It seems to me trading in stock is just making money on other people’s work, and I can’t see the value it adds to society.
I do see the value when it comes to investing in small businesses, or giving workers a share in the company, but when that stock is resold, as far as I can see, the wrong people are making money. Shorting seems suspicious to me - daytrading I can’t understand how is even legal.
So, what is the service to society that wall street brokers are being paid top dollar for?

Having a vibrant second ary market for stock is very important to a company’s ability to sell stock in the first place. This liquidity not only improves stock prices it also makes pricing more accurate.

With that said, we do not need to permit short selling. Short selling adds almost no value to the market and it can cause great harm. Every time you short a share of stock you are creating a virtual share by borrowing a share (which stays on that lenders accounts) and selling it to another erpson (who also credits their account with that share). And that assumes that you catually borrow the share before you short it. In many cases people are shorting shares that they never bother borrowing in the first place. Its against the rules but teh SEC has never been particularly good abotu enforcingrules if it gets in the way of Wall Street making money.

Day trading is speculation pure and simple and frankly large isntitutions do it all day every day, I don’t see why we would bar individuals from doing it.

Wall Street brokers get paid for a lot of things and facilitating stock trades is probably not the biggest revenue generator on wall street. What they do on wall street is being made obsolete by online platforms.

[Damuri_Ajashi]

@sachertorte

If I understand things correctly, the financial meltdown wasn’t due to stockbrokers in the traditional sense. The meltdown came from fancy financial instruments made up by non-stockbrokers. More importantly these fancy financial instruments were grossly mislabeled regarding their risk. Something to the effect of “This investment is super safe because equation X said so!”

Leverage, another term that I don’t think I fully understand, also seems to have something to do with it.

Stock in its most traditional sense didn’t seem to have much of anything to do with it. In other words, this wasn’t an Enron where they cooked the books to make the company look good and artificially inflate the stock price.

Am I naive? Are stockbrokers “the enemy?” (I’m asking seriously).
Let’s say I have a pile of money that I want to invest. How do I invest it without helping out The Evil? Or do I have to not invest it at all?

Stock brokers are not the enemy. Wall Street in an abstract sense is not the enemy. It is the influence Wall Street’s money has purchased in DC alongside the nearly religious faith some politicians have in the markets ability to regulate itself and fix everything “if we would just get the government out of it” that is the enemy.

[Damuri_Ajashi]

@yelimS

I don’t think it changes anything that traders are making money on other people’s behalf. That just means a bigger group are making money off everyone else. Where I live, we have a very good pension fund - the traders working for it are certainly benefiting my future self, but as far as I can understand, at the expense of people in other countries who come out on the losing end of their deals.
As far as I can see, everyone gains from the efforts of producers (of food, clothing, houses, art, &c), but stock trading seems to me like a zero-sum game, where you can’t make money without someone else losing that same amount.

I think that is my refined question - is stock trading a zero-sum game?

Well, not really because over time you can expect economies to grow and the stock of the corporations that constitute that economy to grow along with it.

[Damuri_Ajashi]

@CurtC

As I mentioned in my post, I’m here talking specifically about the transaction that goes on between me and you, at a point in time after my $20 investment with Groupon (to use your example).

The transaction between you and me is zero-sum. I had a share of Groupon, you had $30. Now you have a share of Groupon and I have $30. That’s zero-sum. The investment with Groupon, with which they can buy more computer equipment and programmers, had already happened. That part is NOT zero-sum; just the transaction between you and me.

Well a zero sum game is clearly exhibited by folks who own opposite sides of a commodity futures contract. to the extent one side gains money, the other side loses.

[Damuri_Ajashi]

@yelimS

Omar Little: But if the company appreciates by 7%, how is that thanks to the shareholders (unless they are workers or original investors)? I get that part of the value for workers and investors of having shares is the ability to sell them, and it’s hard to draw a line in the sand here, but at some point, it seems to me that people are making money off a company’s performance (or lack of it, in the case of shorting), without contributing to said performance. That’s what I want to hear justified, even if zero-sum game is the wrong concept to explain what’s going on.
Again, I’m not asking what’s to be done about this, and my hunch is that some trading is good, but excessive trading isn’t - if that’s the case, it might be hard to regulate away the ‘bad’ trading.

Do you believe that the folks that invested in a company when it was just starting out have created value and deserve to share in the growth and appreciation in the value of the company?

Do you think that initial investor should be able to sell their stake in that company?

Do you think the person who risks their capital and buys the share from that initial investor deserves whatever wealth the initial investor would have gotten if they had kept their stock?

rinse repeat.

[Damuri_Ajashi]

@puddleglum

The OP seems to be concerned with speculators and day traders as opposed to stockbrokers. The benefits of speculation is that they smooth price changes which gives people time to adjust to the price changes. For example if there is an earning report on how a company is doing due on December 1st. Speculators try to gather information on the company and if they think the company will be do well in the report they start buying stock in the company in November. The price of the company edges up every week and then when the positive report comes out the price has a small bump. If speculation was not taking place when the report came out the price would suddenly jump up. Huge spikes and drops in stock prices are not good for the market as a whole. Speculators are always the whipping boys of executives whose companies are doing poorly, but they provide a useful service to the market and the market provides a useful service to society.
An example of a market without speculators is the onion market. Futures in onions were outlawed in response to an attempt to corner the market. Onion prices are significantly more volatile than those for other vegetables, hurting both buyers and sellers of onions who can not plan as well as they otherwise would be able to.
The recent unpleasantness with CDOs and mortgages which has so many angry at Wall Street had almost nothing to do with stocks and involved bonds, which is where the money really is.

Speculaation can also lead to bubbles.

[Damuri_Ajashi]

@yelimS

Ravenman: I don’t understand your beef - I just wanted to know what the benefit of trading is, something puddleglum and JohnT answered excellently. If it had been the case that the entire profession was parasitical, earning money on a practice that did no good at all, then I would bloody well be entitled to criticise it. I didn’t, I asked what the benefit was, admittedly without veiling my suspicion that speculators might not be as admirable people as those working absolutely necessary jobs with far lower wages. I stand partially corrected (I still suspect earnings are out of proportion with services offered), but I do not feel obligated to excuse having posed the question.

At some point you are not being compensated for your skill and training, you are being given a small little peice of the pie. This is how you get compensation that seems outsized compared to what is being done but lets not forget that these are not hereditary occupations (for the most part), anyone that has the drive and ability can try and get one of these jobs (an argument the right will support when it comes to compensation for anyone except those “grossly overpaid” government employees).

[Damuri_Ajashi]

@Rand_Rover

You didn’t understand my post. I’m trying to get you to take a step back from the issue you are asking about and think about why you asked the question you asked in the first place. You seem to think that a thing has a “right to exist” only if you personally are convinced of its usefulness to society. I’m wondering why you are so enamoured of your own opinion about a thing’s usefulness to society.

Look, I would be perfectly happy if the world did not contain Justin Bieber’s music, dildoes, Indian food, the lottery, Occupy protests, and probably a hundred other things. But I don’t ever think that anyone has to prove to me that those things benefit society. Some people like them, so they exist, and that’s really the end of it.

I think he’s wondering whether it would make sense to regulate the activity in such a way that the negative aspects are minimized.

[Damuri_Ajashi]

@Rand_Rover

Nope. It is impossible for “x is necessary” to be a fact–it can only be an opinion.

Change necessary to societally beneficial (whether economically or socially) and see if that makes more sense to you.

[Damuri_Ajashi]

@ralph124c

It seems to me that stock trading is always going to be a game in which information is key. If you know that corporation X (Solyndra) is about to go belly up, you can make fast money shorting the stock.
The vast majority of investors never have access to up-to-the-minute information about a companie’s status-that is why it is difficult for small investors to make short term profits in the market.
As for long term profits..buy and hold (Warren Bffet) is probably the best strategy to make money.

Technical traders would disagree. They would say taht all the information you need is reflected in the price of the stock. The price action of stock will reflect when some insiders start trading on their knowledge that some company is going to go bankrupt or reveal it has discovered the cure to being fat.

[Trom]

@Damuri_Ajashi

…

With that said, we do not need to permit short selling. Short selling adds almost no value to the market and it can cause great harm. Every time you short a share of stock you are creating a virtual share by borrowing a share (which stays on that lenders accounts) and selling it to another erpson (who also credits their account with that share). And that assumes that you catually borrow the share before you short it. In many cases people are shorting shares that they never bother borrowing in the first place. Its against the rules but teh SEC has never been particularly good abotu enforcingrules if it gets in the way of Wall Street making money.

…

Egad, no! Short selling is a very valuable part of the market place. When short selling was banned temporarily a few years ago volatility went absolutely bonkers! Studies on the ban show no positive effects from the ban, and quite a few negatives.

Regarding the current short ban in Europe - a report from EDHEC Business School in Europe:

EDHEC-Risk Institute condemns the August 11 decisions by the financial market authorities in Belgium, France, Italy and Spain to impose or extend short-selling bans in the wake of renewed market volatility.

These hasty decisions are not only devoid of theoretical basis, but also fly in the face of empirical evidence. Academic studies, including work by EDHEC-Risk Institute researchers, have documented the positive contribution of short-sellers to market efficiency and shown that constraining short sales significantly reduces market quality – by reducing liquidity and increasing volatility – and can have unintended spillover effects.

In a series of research articles, EDHEC Business School Professor Ekkehart Boehmer and his co-authors have studied short selling activities, looking at the type of information possessed by short-sellers, at the impact between short selling activities and abnormal returns, and at the link between short-selling and the price discovery process. They established that short sellers are important contributors to efficient stock prices, that short interest contains valuable information for the market, that information is impounded faster and more efficiently into prices when short sellers are more active and that short sellers change their trading around extreme return events in a way that aids price discovery.

[Fear_Itself]

@Damuri_Ajashi

Do you believe that the folks that invested in a company when it was just starting out have created value and deserve to share in the growth and appreciation in the value of the company?

That is what dividends are for, to participate in the wealth created by the company.

[Damuri_Ajashi]

@Rand_Rover

That’s the notional value of all derivatives in the derivatives market. That’s not the amount that people have “managed to gamble.” I’ll wait right here while you read up on what the notional value of a derivatives contract is.

For things like currency swaps and interest rate swaps, this may be true (and these two things probably account for a pretty big chunk of the derivatives market) but we both know that a lot of derivatives are not hedges nor is the risk limited to a small portion of the notional value. Sometimes these derivatives intentionally create risk where risk did not exist before and put a significant portion of the notional amount at risk in blasck swan scenarios.

[Damuri_Ajashi]

@DragonAsh

:rolleyes:

You clearly don’t have the first clue about what derivatives actually are or how they are used. You do know that Mr Buffet himself also trades in derivatives, his rhetoric notwithstanding? Do you know why? Because used correctly, derivatives are damn useful.

Fire can help provide warmth, food, and energy. You wouldn’t ban fire just because it can also burn your house down.

The overall level of misinformation, misunderstanding and general ignorance in this thread is so off the charts I can’t quite wrap my head around it.

Yeah but 500 trillion dollars in notional principal value is a LOT of fire.

BTW the derivatives that Buffett was warning us against wasn’t run of the mill interest rate and currency swaps, its was stuff like credit default swaps, syntheic CDOs and stuff like that.