The Case for the Stock Market

Back in my years as an undergrad, I can clearly recall having a particularly heated argument with my friend about why investing in the stock market is morally wrong.  I argued at the time that the stock market was simply a vehicle for the rich to get richer - their surplus of research, resources, and technology enabled these big banks, pension funds, insurance companies, and hedge funds to profit at the expense of the common man or woman. The arguments I used at the time are the same that I consistently hear today: 

1) The stock market ultimately does not provide any marginal value for the larger public. Some people benefit in extraordinary ways, most others lose, and the net result is not meaningful or beneficial for society as a whole. 
2) The stock market is a zero-sum game. There must always be a winner and a loser, and in the end it only benefits the wealthy because of their unfair availability of resources. 

While there is some validity in these oversimplifications, they also do not give credence to the benefits that the stock market does in fact provide to society. 

Why the Stock Market Exists
There are two ways that companies can raise money: debt and equity. Debt is essentially borrowing money that needs to be paid back over time, typically with interest. When you take out a mortgage or car loan, for example, you will have to pay back the full amount (principal) plus interest. However, equity is not something that needs to be "paid back". With equity, you are purchasing ownership in the asset. Again, in the case of purchasing the house, your outstanding mortgage is your debt, but the house itself is now your equity. 

In the same sense, when you buy a share of a company (equity), you are buying a small ownership stake in the company. The existence of the stock market is to facilitate the buying and selling of these ownership stakes of these companies. By issuing shares to the public in a process called an Initial Public Offering (IPO), people are then able to participate in the potential growth and success of a company. John Roberson provided a great response on Quora here that details the thought process behind owning a portion of a company, and how these shares can grow in value. Once these shares are issued, the company receives an influx of cash from the public (IPO proceeds), because they want a piece of the future earnings & value of the company as it continues to generate profit and grow. By issuing equity instead of debt, companies can receive this funding without having to pay anything back. 

How does this actually benefit society? 
1) Provides incentive for investors to take chances on potentially revolutionary ideas
2) IPO proceeds can be used by the company to re-invest in its business, and thereby provide an even better product or service
3) Provides liquidity and opportunity for individuals to participate in the growth a company, or even the growth of the entire economy

Consider this: 

Most great business ideas need funding. For example, if you are an incredible cook that wants to start a restaurant, or if you have a revolutionary idea to build rockets that can launch, land, and be reused, then you're probably going to need a lot of funding. Visionaries and their teams have ideas that can change the world. Investors who see the utility and vision of the idea decide to invest and provide the capital needed in order to bring these ideas into fruition. Some operations can start small and scale as they grow, but others like SpaceX need huge amounts of initial investment in order to build factories, hire engineers, etc.

But even if an idea is great, what would convince an investor to give up that much money? Investors could loan out money (debt), but this could hinder the aspiring company's future growth, and the return for the investor would only be principal + interest. This is where an IPO can come into play - by issuing equity, a company that isn't even profitable yet can get a huge influx of cash, and also give investors a chance to "close" or "exit" their position. These shares are often valued highly because the market believes in the future earnings and value of the company. Those initial investors can then sell their shares, which represents their initial investment, on the open market for likely more than 2x the original investment. For example, Amazon's S-1 filing reported a net loss of about $5.8M for the year ended Dec 31, 1996, meaning they were definitely spending more money than they were making at that point in time. Now, for the twelve months ended June 30th, 2018, Amazon reported a net income of $6.275 billion. At almost any period of time since its IPO, any given person investing in Amazon for a year or longer would have made a solid profit. People paid for Amazon shares back in 1997 because of their expectation of future revenue growth and profit. Any investor that purchased shares back then and somehow managed to hold onto them until today has now earned approximately 1,000x return. Not bad. This venture capital funding (and subsequent participation of individuals like you and I through IPO and beyond) are what help to drive innovation in the economy. Without initial venture capital funding, many companies would not have the capital needed to even launch their idea. And without the stock market, many venture capital firms would not have the incentive to invest in these ideas (or at least not the same willingness to take on risk for unproven ideas). Without these companies, we would be potentially missing out on some of the greatest technological innovation of our time. 

Again, the overall process could look something like this:

  • Company X is a fledgling startup that needs capital to execute its vision of being able to deliver anything anywhere anytime.

  • Venture Capital firm VC is willing to bet on Company X's ability to deliver on this vision, and decides to invest $50M.

  • Company X takes VC's money and hires a bunch of engineers, builds factories and drones, tests the fleet, and launches its business.

  • Company X is wildly successful, with huge revenues and a growing number of users, but it's not yet profitable.

  • Company X decides to move forward with an IPO. The shares of Company X now have a clear monetary value on the open market, with many institutional and individual investors buying shares.

  • VC decides to sell off its shares for a profit of $300M.

  • You decide to buy 50 shares of the stock at IPO for $10/share.

  • Over the next year, Company X uses its IPO proceeds to build new factories and warehouses in other parts of the world, making drones available for delivery in several new markets. It continues to expand its business, and leverages economies of scale to produce drones at cheaper rates, lower shipping costs, and generate more revenue per user. Its share price is now $30.

  • You decide to sell your 50 shares at $30/share, giving you a total profit of $1,000 before tax.

  • Your coworker John mentioned that he recently bought 50 shares of Company X for $30/share.

  • Company X continues to perform well, and the price climbs to $50/share. John sells his position, and also nets a before-tax profit of $1,000.

In this way, the stock market can provide means for everyone involved to gain from the growth or success of a business.

But isn't trading just a zero-sum game? 
In the previous example with Company X and your coworker John, it's clear that a person who purchases and sells a stock after the IPO can still benefit. If Company X continues to grow, and its share price climbs to $70, $100, etc., then the next person can still benefit from buying and selling Company X stock. 

However, not all companies succeed. For many tech companies that go public and start out with huge net losses, the promise of future profits never materializes. Even companies that are big enough or successful enough to become listed on major stock exchanges can go bankrupt. There is a myriad of factors that can affect stock price, and people can certainly lose huge amounts of money in the market. But the existence of huge losses does not equate to a zero-sum game. In fact, holistically speaking, the overall market continues to grow in value, as seen by various US market indices like the Dow Jones Industrial Average, S&P500, Nasdaq, and Russell 2000. Over the long term, the stock market absolutely is not a zero-sum game. 

But what about the big institutional investors? Aren't they always going to beat out the 'little guy'? 
Large institutional investors almost always have better technology (carefully-tuned algorithms, Bloomberg terminals, etc), insider information (though legal action and policy are trying to help prevent this), or other research material that is generally not available to the public. They are better equipped, informed, and managed than the average individual investor. But again, the stock market is not a zero-sum game over the long term. Just because the institutional investors have better resources does not mean that you, as an individual investor, cannot earn a profit. For example, let's say you invested $10,000 in ITOT (an index fund that tracks to the total US market) at the height of 2007 before the 2008 Financial Crisis. The crash hits, you lose a ton of value, but you continue to hold onto those shares. Ten years later, your investment would be worth over $17,000. This assumes that you buy essentially at the worst time possible, and eat the full loss of the crash. The returns would still be far better than keeping your money in treasuries or in the bank earning interest. Over time, barring truly unprecedented, catastrophic, geopolitical events or the return of Jesus, markets will continue to grow in value over time, and the 'little guy' can still benefit from it. (But note that the same cannot be said of investing in a single company's stock. My illustration is specifically referring to investing in the overall US market.) 

It remains my conviction that the stock market provides significant value to society as a whole, both for large institutions and for individuals like you and I. However, greed, misfortune, and other circumstances can cause people to take huge losses from investing in the market. Always invest with wisdom, and follow principles that will stand the test of time. 

-Ezekiel Emunah

Ezekiel EmunahComment