Broad Oak: your emotional support animal

Wednesday, July 27, 2011

The Stock Market made simple?

A correspondent on Usenet took umbrage recently when I referred to traders as (possibly necessary) parasites on the economic system. That he used to be one probably had something to do with his outrage, but I meant the term in the biological sense, in that traders generate no wealth, nor provide any real service, at least in my simplistic understanding.

Perhaps the illuminati here can shed light on my misunderstanding by considering the following simple scenario:

1. MomandPopCo decide to expand, and so release an IPO of 2,001 shares. They keep 1001 to have majority control, and sell the rest for $100 per share. With a 1% fee charged by the brokers, they realize $99,000, and the latter get $1,000
2. A short time later, Amy sells her 100 shares for $105 per share to Bob. She gets $395 in profit, and the brokers get $105 for their service.

Questions:

1. Where does all of the money come from?
2. Why does Bob pay more for the shares than Amy did?
3. Why was Amy able to charge more than she paid?

The answers are clearly(?):

1. From the investors.
2. Unless Bob is an idiot, he assumes that the stock price will either further increase, or the dividends will cover his costs.
3. Amy must be taking the discounted value of the future dividends of the company, or we are starting yet another bubble. This is easier to see if the company is buying and raising cows for sale, being a transaction of finite duration.

Notice that the company does not benefit at all from the second transaction. Even if their stock goes up, they cannot sell any more without losing control.

6 comments:

James Higham said...

4. How to cut out the brokers?

Sackerson said...

No, noooo...

Nick Drew said...

they will nevertheless benefit from their shares being traded, even more so if the stock is rising

corporately they may be able to raise more by way of loans (not necessarily secured on the stock)

personally they could raise money secured on their remaining shares

(& they may not lose effective control even if they float more shares)

and if they ever needed to sell in a hurry, at a fair price, they'd be VERY glad of a buoyant & liquid market

liquidity is a Public Good (as you'll know if you've ever needed it ...)

(PS, either Bob or Amy may well be idiots: or both - we must all have seen even large corporate investment decisions that have been crass)

Paddington said...

Nick - I am not arguning against trading. I am simply pointing out that such transactions do not create wealth.

Paddington said...

Nick - as to one other comment, if the company tries to sell its shares in a hurry, won't the price drop quickly?

Nick Drew said...

maybe, maybe not: depends on circumstances

such transactions do not create wealth - taking the broad view, I can't really agree for reasons stated above: making a market, in anything really, is one facet of how wealth 'comes about', in capitalism

even idiot Bob has his part to play