Harley Hahn - Economics Explained - The Stock Market and Faith

Money and
Economics

The Stock Market and Faith

(November 28, 2011)

Summary: In the long term, the price of a stock reflects the profitability of underlying company. However, this is the case only because people believe it to be so, and act upon their beliefs.

To many people, the stock market is a mysterious and unpredictable paramour who will reward us if we invest well and punish us for making poor choices (or for having bad luck). However, the truth is, investing in the stock market requires something more than astute judgment and good fortune: It requires faith — and blind faith at that.

To understand why, we need to start with the basics.

Suppose I own a business that needs to raise money, and I want to get the money from you. I have two choices. First, I could ask you to loan me the money for a certain amount of time. I might promise to pay back all the money on a specified date and, until that date, I would agree to make regular interest payments. (In effect, I would be selling you a bond.)

The second choice is that I could offer to sell you a percentage of the company. For example, I might offer you 5 percent of my company for $10,000. In this case, I never have to pay back the money. Instead I make you the following four promises:

1. Profit Sharing: You will share in the proceeds of the company. For example, I might promise that at the end of every quarter, you will receive 5 percent of the profit earned by the company.

2. Liquidation: If we ever sell the company, I promise you will receive 5 percent of the profit arising from the sale.

3. Voting Rights: Whenever we have meetings at which important decisions are made, you will be invited to attend, and you will have 5 percent of the voting power.

4. Selling Your Shares: At any time, you have the right to sell your share of the ownership of the company to someone else. If the company becomes highly profitable, your 5 percent share will generate more and more profit for you, and you will probably be able to sell your share for more than the $10,000 you paid for it.

Let us now compare this scenario to buying stock in a much larger company, such as IBM. As I write, the current price of one share of IBM stock is $178. Thus, for a bit less than $10,000, you can buy 56 shares. Suppose you do so. What do you get for your $10,000? In other words, why would you want to buy stock in IBM? More generally, why would you want to buy stock in any company? To answer these questions, let us consider the four points we just discussed.

Profit Sharing

IBM has 1.2 billion shares outstanding. When you buy 56 shares, the percentage of the company that you own is 56 divided by 1.2 billion, which works out to 4.7 millionths of a percent (0.0000047 percent). Last year, IBM made a profit of $14.83 billion. If all of this profit were divided proportionally among the shareholders, your share would be $692. On an investment of $10,000, that's almost 7 percent a year, which is an excellent return on your investment.

However, like other companies, IBM does not distribute its entire profit to its shareholders. Instead, the company retains most of its profit. However, IBM does pay a dividend once a quarter. Over the last year, this dividend was 75 cents/share per quarter, a total of $3.00 for the year. Since you own 56 shares, your dividend for the year would be $168 (56 x $3.00). On an investment of $10,000, this is a return of 1.7 percent.

Is this a good reason to invest in IBM? Well, in a poor economic climate when interest rates are low, 1.7 percent a year isn't bad. However, you must remember that as an owner of IBM shares, you take the risk that the value of your shares might go down, so there is a real possibility that when you sell your shares you won't get back all your money. Moreover, many companies (such as Google, Facebook, and Berkshire Hathaway) never pay dividends, but you still run the risk of the value of your shares declining.

Thus, if we want a good reason to buy stock in IBM or in any other company, we need to look further.

Liquidation

The chances of IBM or any large company being liquidated in a way that benefits you is zero. Thus, realistically, this is not a source of potential profit.

Voting Rights

As a holder of 56 shares, you do get 56 votes at the IBM annual meeting. However, considering that you own only 0.0000047 percent of the shares, your votes are virtually useless. More importantly, they aren't a source of profit and, hence, do not represent a reason to buy the stock.

Selling Your Shares

This is where you have the chance to make real money. At any time, you have the right to sell your shares in IBM. This is easy to do because they are always people willing to buy your shares for the going rate. (In technical terms, we say that IBM shares have a high liquidity.) In fact, it is only by selling your shares that you can hope to make a significant profit from your investment.

Compare this to other types of investments. If you buy a house, it may go up or down in value over the years. However, between the time you buy the house and the time you sell it, you can actually live in it. If you buy a second house, you can rent it. If you buy land, you can build on it or grow something on it. If you buy a painting, you can look at it. If you buy a bond, you will receive regular interest payments, along with a promise that, one day, your original investment will be repaid.

With a stock, however, the only way for you to make money (aside from the possibility of a small dividend) is to sell your shares to someone else for more than you paid for them. Thus, the only reason you would be willing to buy shares in IBM, or any other company, is if you believe that, eventually, the value of those shares will go up. It thus behooves us to ask the question: What makes the value of a stock go up?

What makes the value of a stock go up?

Even though the stock market is complicated, the answer to this question is simple. Over the long run, the price of a stock reflects the profits of the company that issued the stock. The more profit a company makes, the more its stock will be worth. For example, if the market perceives that IBM's profit will increase significantly in the near future, the price of IBM stock will go up.

But why should the price of a stock go up just because people believe the company is becoming more profitable? If IBM becomes more profitable, how does this help you, the owner of 56 shares?

The answer is, it doesn't. IBM will never liquidate, so you'll never make any money that way. And your voting rights, for practical purposes, are worth nothing. To be sure, if IBM's profit goes up the company may increase its dividend. However, almost always, such an increase will be insignificant. (And remember, many companies don't even pay dividends.)

The price of a stock reflects the profitability of a company because people believe that that's the way it should be.

The truth is, the only reason the price of a stock reflects the underlying profitability of the company is because people believe that that's the way it should be. And because people believe it, that is what happens. It is this widely accepted belief that causes stock market analysts around the world to spend countless hours trying to figure out which companies are going to increase their profits and by how much.

The important thing to realize is that, unlike houses, land, bonds, or even paintings, shares of stock have no value on their own (aside from the possibility of a small dividend). In fact, there is only one thing you can do with shares of stock: sell them to somebody else.

But why would someone be willing to buy your stock? After all, once he owns the shares, all he can do is sell them to a third person, and all that person can do is sell them to another person down the line. It's like a game of musical chairs in which the music never stops.

If you own 56 shares of IBM and the company makes more and more money, it doesn't increase your profit directly. The value of your stock will go up, but only because of the shared belief that that's how the system works.

In other words, at its most basic level, the stock market runs on blind faith — faith in a belief system that is so fundamental that it is rarely articulated and never questioned.

At this point, you may want to read...

Is There a God?