Understanding Stock Markets

This post is not going to help you get rich off the stock market. If that’s what you’re looking for, the best advice I have for you is to understand your desire makes you a mark and study up on scams of various sorts. That’s fun to do anyway, and I don’t understand why cons aren’t a bigger part of true-crime publishing, and you’ve probably moved on already because you think I just insulted you.

Photo of a graph in a newspaper. Graph shows a year of Dow Jones Industrial Index values.
Photo by Markus Spiske

This post exists because most financial education in the U.S. is a sales pitch, either directly or for a particular school of economics. I came at the stock market as a pension analyst whose job it was to understand the assumptions inherent in funding pensions. Also as someone who finds the history of fraud fascinating, but you may have picked that up. I did this work in the post-Enron regulatory environment in the U.S. and through the collapse of housing bubble plus a few years. This is where I ended up on funding retirement.

This post exists to give you a basic framework for understanding investing events and scandals. Consider it a skeptical but not cynical high-level guide to (mostly U.S.) stock markets.

  • At its most basic, there are two ways to fund projects that cost more than you have: borrowing and selling a direct financial and/or decision-making interest in you.
  • There’s really a third way to fund private projects, through grants. And a couple of ways governments can fund projects that aren’t generally open to others. These aren’t widely considered investing, though, and that’s a philosophical decision that has a heap of influence on the shape of our society.
  • As individuals, we mostly understand borrowing. We don’t see much selling financial interest in individuals, because that’s a recipe for abuse, but you’ve probably heard of indentured servitude to pay for immigration.
  • Companies can also borrow or sell an interest. Sometimes that interest is sold to a single individual who becomes a silent partner. Sometimes it’s sold to another company. When that interest is made available more generally and in smaller pieces (shares), we’re talking about stock.
  • There is typically risk on both sides of this transaction. Lenders and investors risk fraud and honest financial failure, both of which mean they don’t get their money back. Those who borrow money or issue stock risk predatory tactics. Think conditions that trigger balloon payments, causing default and repossession, or private equity firms that strip companies for short-term cash.
  • Stock markets, in their basic form, exist to facilitate the purchase of shares in companies. They provide a central place for the transactions and often, both directly and through third parties, provide information for their users to assess risk.
  • A stock index is both information and a product for investors. As the cost of a set number of a set variety of stocks, it tells us how well a market does over time. As an index fund, it’s a chance to buy into a set of stocks with a very well known history.
  • Stock markets, in theory, rationally convert this risk and the attendant possibilities for reward into stock prices. In reality, our models for this conversion are hugely complex, and humanity isn’t great at assessing long-term risk and reward. Also, some people cheat.
  • Things investors look at to determine risk and reward include company history, industry outlook (coal stocks just fell hard), income volatility, profit margin, assets, confidence in company executives, company press coverage and PR, competition, dividends (direct payments to stock holders), capitalization (the value of stock issued compared to the value of company assets), etc. and on. As I said, complex.
  • I can’t actually tell you how well investors do at assessing risk and reward in most cases, and neither can anyone else, because the value of a stock is what everyone decides it is. If you own a share of stock that doesn’t pay dividends, its value to you is what someone else is willing to pay you for it and you are willing to accept. The system isn’t unresponsive to good or bad company news, but it’s chaotic. There isn’t one single, objective determining entity or metric driving stock prices.
  • Nonetheless, it is kind of true that a company is worth what people are wiling to pay for it. That means companies that want to borrow for shorter-term needs rather than issue more stock are still dependent on the value of their stock. It is one proxy for the value of their company that banks and private-equity firms use to determine their own risk.
  • I mentioned that people cheat. One of the primary ways to cheat in stock markets is to change what people are willing to pay for a stock. This can be done through hiding information about a company, sharing disinformation about the company, creating a false appearance of a stock’s trading history, and much more. People are very creative.
  • Timing is another way to cheat. Investors are supposed to compete with each other on a level playing field in that they get access to the same information at the same time. Insider trading is the best known form of cheating on trade timing.
  • Stock trading is regulated to prevent and penalize cheating. How well it accomplishes that depends on the willingness of officials to provide oversight, the pace of technological change creating new ways to cheat that may not be detected or even illegal, and how well the relevant laws and regulations cover the behavior they mean to cover.
  • Companies—remember companies? Stock markets exist to fund companies, but we’ve gotten pretty far from that, both in this post and in modern markets. It’s not easy for a company to become publicly traded. One of the things that means is that companies rarely go private again, so technically the money invested in stocks mostly doesn’t get paid back by the companies.
  • When companies do pay off their stock debt, this is called a stock buyback. That they are controversial is a function of our society’s fundamental disagreements about what companies are for. Do companies serve their customers, their employees, their investors, their communities, or their industries, and what do they owe to each?
  • Ugh, Milton Friedman. The U.S. in my lifetime has generally considered the primary purpose of a for-profit corporation to be to maximize value for shareholders. It’s been bad enough that a special kind of corporation was created to say, “Uh, not us. We have wider concerns than that.” The hold of this idea may finally be loosening?
  • This was only reinforced when company executives started receiving large portions of their compensation in company stock/stock options.
  • I don’t have a good sense of how much of the money generated by companies’ first stock offerings (IPOs) is used to fund their projects these days. (Remember projects?) The kind of IPO most of us are familiar with from press coverage is the tech startup, where the IPO is how venture capital gets paid back or where an owner-operator cashes out after burning out on unsustainable business practices. I know some does still fund business expansion, though. [ETA: A friend who works for a media company that covers IPOs says planned expansion is still the main reason given for IPOs.]
  • So what are stock markets doing if they aren’t funding capital projects? That is an excellent question. No, really, that’s a question that is so fundamental to the concept of stock markets that it doesn’t get asked very often, at least from the inside.
  • I call this non-productive stock trading the predatory gambling market that floats on top of our stock market. That’s slightly hyperbolic, because even if it were standard practice for companies to buy back their stock, there would be plenty of stock issued for as long as it took to buy it back. Investors would still need to cash out some of their investments early. There would still be trading.
  • The “predatory” part is less hyperbolic. When stockholders are given precedence over all other stakeholders in a company, the other stakeholders suffer. They have to. Stakeholders don’t all have the same interests.
  • Yes, it really is gambling. The vast majority of investors—individual or professional—do not outperform the overall markets in which they invest. When they exercise their judgment, they do worse than the relevant indexes, which is why index funds are the recommended option for retirement funds. (They also cost less in fees because they save labor.)
  • The people who do outperform the market in studies? Well, some of them have to. We can’t all be above average, but someone has to be if there are differences. That doesn’t mean they will continue to be above average going forward. Regression to the mean is a thing.
  • However, as with any gambling culture, investing is superstitious. Calculating real risk and reward is complex. Exercising your biases is easy. So, is that person who’s done well with picking stocks in your experience really the smartest person in the room (at stock-picking), or are we dealing with survivor bias?
  • Sometimes unusual success means unusual business practices, by which I mean fraud.
  • Sometimes success means having enough money to buy control of companies that have lots of potential but unprofitable practices you want to change. That’s not replicable for most of us.
  • Sometimes success means having enough money (or credit) to change the behavior of a stock in the short term. Still not very replicable.
  • Sometimes success means more success unconnected to any particular company or investment strategy. People will follow your stock picks, with their interest causing your stock to increase in value. Or you can get rich selling books and classes telling people how to get rich.
  • Playing follow-the-leader in stock markets has one very well known side effect: bubbles. A bubble is when the price of a stock or group of stocks rises because it has risen recently rather than based on valuations of the underlying companies. Like a soap bubble, it rises on hot air. And like a soap bubble, it’s fragile. Even if it doesn’t hit something, it will eventually become unstable, pop, and fall to the ground.
  • Burst bubbles are terrible for the actual economy. Enough money can get concentrated and lost in them to affect the amount available to everyone else for capital projects. (Remember projects?)
  • Burst bubbles are terrible for late investors, who tend to be smaller, more naive investors. This means bubbles reinforce existing inequalities in wealth.
  • Related to the Gamestop mess: If people in the media are calling something a bubble—not just worrying about bubbles but calling it—you are very near or past the point where you can make money by buying the stock involved. If you really think it’s a good stock, wait until it crashes hard. Or just don’t.
  • There is some evidence that too much money available to stock markets fuels the formation of bubbles. This is reasonable, given that investors can’t fund more projects than actually exist in companies. Once that money stops being usefully employed, it’s more likely to court risk in search of return.
  • There are ways to take money out of the markets in ways that make bubbles less likely. They’re pretty popular with smaller investors. A few decades of heightened volatility means they’re getting there with the investing class as well.
Understanding Stock Markets

One thought on “Understanding Stock Markets

  1. 1

    You just reminded me why I got out of the market as soon as I could. I have friends who are invested and don’t sleep well at night when it wavers. I have ethical qualms about how/why it functions. What I don’t have is a crystal ball that could override my need for financial stability, so my investments are elsewhere. I’ll trade rich fantasies for security – except for a very occasional lottery ticket! Dang it, those fantasies are fun.

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