The Only Two Sources Of Money in the Stock Market
All the money that ever has been made or ever will be made “in the stock market” can be divided into just two sources.
- Money made from other investors
- Money made from the profits of serving the customers of businesses that trade in the Stock Market
In many ways the above fact is obvious. Yet it may also be somewhat surprising to many investors who have never really stopped to think about it. In any advent, it is worth considering the implications of the above fact.
Many investors could be forgiven if they thought that all the money to be made in the stock market must come from other investors. Most of the attention on the stock market focuses on making quick money by buying and selling at the right time. In fact making money from other investors is definitely one of the key purposes of the stock market.
However corporations do not primarily exist for the purpose of investors to make bets against one another. Corporations exist to make money from their customers. (There are rare exceptions where a company is set up for the purpose of robbing money from investors, but that is a rare and presumably illegal exception.) Even corporations with really stupid ideas that will probably never make money at least hope to make money from customers at some point.
The essence of the stock market is that stocks are valued at the present value of the expected future cash flows that the corporation will ultimately provide to investors. At any given time there is wide divergence of opinion as to what this value is. The stock price is set by the intersection of the lowest value perceived by a current stock owner and the highest value perceived by a willing stock purchaser. This value can change radically as opinions change even if nothing about the company changes. But the company itself is constantly changing, which affects its value. And interest rates or returns on competing investments are constantly changing. The result is that the market value of any company on the stock market is constantly changing. In essence investors are constantly trying to outsmart each other and buy stocks that they expect will rise in price to provide an above average return and sell those that they expect will falling or be stagnant in price resulting in a below market return.
For every stock trade, one investor will be proven correct and the other will be proven wrong. The apparent winner of each trade may change many times depending on the time frame. Perhaps after 1 week the seller looks like the winner as the stock sinks. But perhaps after 5 years the buyer is the winner because the stock is not only up but has returned an above market rate of return.
As the market makes its determinations of the value of each stock, that value is based on future profits from customers. If there will never be any profits from customers then the true value of the corporation is the salvage value of selling off its assets and paying off its creditors.
If we look at the sum total of all the money that is made from other investors, it is immediately clear that for the total population of investors this amount must be zero (before trading costs) since all the gains are offset by someone else’s losses. In fact the true grand total of all the money made from other investors across the total population of investors is far less than zero when one considers trading costs.
The inescapable conclusion then is that all the Money that ultimately will ever be made in the stock market must come from the profits of serving the customers of the businesses that trade in the market.
Having hopefully brought to your attention that stock trading is a negative sum game while stock owning is a positive sum game, perhaps I could stop here and simply allow you to ponder for yourself the implications. However, I do offer below my own view of the implications.
There are important implications of the above facts for investors.
If you want to try and make money by buying the stock of a company that is not currently making profits and which will likely never make money, then virtually your only hope is that you can outsmart another investor and sell your stock to a “greater fool”. In this type of dog company, time is your enemy. You only want to hang around long enough to make some money, ultimately you want to sell before the market realizes the company is pretty much worthless.
If you want to make money in a company that is already making attractive profits and that is expected to continue to do so indefinitely, then as long as you have not paid too high a price for the stock, all you have to do is wait. Here, time is your friend.
It seems to me that it would be easier for most investors to make money by restricting their investments to currently profitable or soon to be profitable companies. If they are wrong and they pay too much then maybe they will make somewhat below the market rate of return. And if they are right they will make a market rate of return or higher. These investors will make or lose some money from other investors but in general the river of cash that is coming in from the profits on customers will insure that these investors always make a positive return in the long run. However some amount of trading will likely be needed in order to move out of a company if it becomes apparent that it will no longer be attractively profitable or if its stock price has simply been bid up far too high. In this strategy investors attempt to make most of their money from customers while attempting to at least not lose money to other traders.
In contrast those who invest in dog companies can only hope to make money from other investors. Meanwhile the losses of these companies is like a current heading to the sewer.
Of course it is inescapably true that some very astute traders can make great fortunes. Just because trading is a negative sum game does not mean that all traders will lose. However, if you are going to be a frequent trader you should first be able to convince yourself that there is good reason that you can expect to win at a game where the average player loses.
In conclusion, investors should invest in profitable or soon to be profitable companies rather than in loser dog companies. Such buy and hold strategies are often derided by traders. But buy and hold investors who invest in attractively profitable companies are swimming with the current. However, investors should not be strictly buy and hold, they should be prepared to sell when the price of a profitable company gets bid up far too high or when it becomes apparent that a once profitable company is no longer going to be attractively profitable. Traders who bravely trade in loser dog companies are trying to make money from other traders (greater fools) while swimming against the tide that is headed to the sewer.
Shawn Allen, CFA, CMA, MBA, P.Eng.
May 8, 2005