Sunday, March 22, 2009

What am I missing?

I am just a mathematician, so my evaluation of economic models is restricted to the analysis of the equations. However, it seems to me that, in a perfect transaction, the selling price must be at least the value to each party.

Clearly, the value to the buyer must be greater than that to the seller. This is usually achieved by adding value. For example, a manufacturer purchases raw materials, or a wholesale merchant moves goods to where the buyers are.

That being said, I do not see where the added value is in the investment market, for a typical investor. The present value of future earnings and stock price are the same for both sellers. The only reason for the purchase is then an imagined increase in price beyond inflation, i.e. finding a bigger sucker.

Is the whole system just a house of cards?


Nick Drew said...

The present value of future earnings and stock price are the same for both sellers

no no no: their discount rates can very legitimately be quite different; as indeed can their appetites for risk; and the portfolio effects of their holding the asset - e.g. for one party the asset may function as a hedge, thereby representing greater value to them

(as well as a number of less-than-rational, or less-than-happy reasons for evaluating future earnings differently - e.g. different amounts of information available to them)

and as for imagined increase in price beyond inflation, i.e. finding a bigger sucker, well sometimes there are indeed bigger suckers, but just as importantly there are just plain Different Views - the very stuff of markets

in particular, views on just what those future earnings will be, given that an element of forecasting (= speculation) will be required: and (to summarise several great men) economic forecasting is essentially astrology with numbers

I could go on ...

Paddington said...

Nick - I understand a little about hedges, and also different levels of risk. However, if 'value' represents the discounted value of stock + dividends, then why would they potentially have different discount rates?

Watching the discussions by the traders on TV, I see not much difference between them and the gamblers that I know.

Nick Drew said...

There are a number of related reasons why people might use different discount rates:

(1) if I am very old and relatively impecunious (and mainly concerned about myself), I am likely to view £1 today as worth more than (say) £2 ten years' hence. My discount rate is therefore at least 7%, maybe much higher

Conversely, if I am younger and comfortably-off, looking to retire in 10 years, I may view the same proposition as an attractive one: in which case my discount rate is less than 7%.

(2) if I am a small and none-too credit-worthy company, my cost of capital may be (say) 15% (if I can borrow money at all in 2009 ...)and my discount rate for evaluating an investment will necessarily be related to that.

Conversely, if I am a AAA-rated company (a big if in 2009) my cost of capital will be noticeably lower, as will be my discount rate correspondingly.

As regards risk: if I am horribly exposed to the oil price (e.g. an airline that has committed to fixed-price holiday flights a year in advance) then for me, an investment in something that will rise in value with oil prices is a hedge, and thereby reduces my exposure.

Since carrying risk incurs (or should incur !!! if you are doing your risk-reporting correctly) a cost, the asset-as-hedge reduces this cost for me; and this represents additional value over the 'intrinsic' value of the asset to another investor for whom it does not represent a hedge - which is maybe why we end up doing a deal for this asset, splitting the difference, and we both reasonably reckon we've done well (even before we consider differing discount rates)

dearieme said...

Didn't Hayek argue persuasively that all costs are subjective, since they are to do with opportunities forgone, which in turn depend on your knowledge and imagination?

Paddington said...

Nick - thank you for the explanation. I suppose it depends of what you define as 'value', then.

My underlying point, apparently badly worded, is that I don't see enough value added by the people moving the stocks around, on top of too high commissions.

Nick Drew said...

Paddington - I misunderstood your original point. Everyone always (and rightly) tries to squeeze out brokers and transaction costs, but it often turns out their services are genuine added-value after all

not to say that retail punters aren't greatly at risk of being ripped off

there is a huge disparity in knowledge and information, for one thing

I favour (a) transparency and (b) draconian penalties for misleading investors !

dearieme, a great point & often very true (another source of big disparities - but also, hopefully, efficiencies)