Stock Market Strategy

When someone makes money on the stock market, must someone else be losing money?

I have been a professional stock trader for the past decade. I found the answer to this question by accident — and it changed my life.

In sixth grade we played a stock market game. We got $10,000 to allocate to any stocks whose prices were printed in the Wall Street Journal, and after three months the allocation that had produced the greatest profit would win the game. I wanted to win, so I asked the teacher why stock prices would rise. “Because people are buying them.” And why do they buy them? “Because the prices might rise, and then they would profit.” The vicious circle in this explanation models stock market participation as a zero-sum game. That is to say, any profit I make comes straight out of somebody else’s pocket. Legalized gambling.

Of course, I didn’t buy that this was all there was to tell of the story. If most all the big companies in the world were on board, as well as all the pension funds and insurance companies, I knew there had to be something more. So every time I met someone who seemed to be smart and knew something about business, I would ask this question. I don’t know if they simply didn’t have a good grasp of the truth or if they were just trying to dumb down the answer for a teenager, but every MBA I spoke with gave me this same zero-sum-game tale. I started to think that business was for people who were singularly not-smart.

During my final semester as an undergrad I was a regular at a bar on campus. I was there every Monday evening after a late class, doing a bit of drinking and a bit of reading. An economics professor sat next to me at the bar, also winding down from the day. He was a fascinating fellow, and we discussed everything from philosophy and religion to travel and wine to family and careers. After building up sufficient respect for the man, I began to have a thought. If anyone can explain it to me, I thought, this guy can.

With great trepidation I asked the familiar question: “Why would someone buy a stock?”

But the familiar answer didn’t come back.

“That’s not the right question, John. The right question is, why would someone offer a stock to sell on the stock market in the first place.”

Oh. This time really was different.

“Both of us are at this bar every week. We like it. It improves our lives. And we pay money to the bar that, if the bar’s business works well, creates profit for the owner.”

That sounds right. In fact, it makes profit sound like a great thing for society, at least in some circumstances.

“But when it comes to starting a business, it takes money to make money. The owner had to commit to a lease on this building, bought glassware and alcohol, installed stools and this lovely wooden bar in front of us, and hired employees. Most people with a passion to start a small business aren’t sitting on cold, hard cash. They have to get it from somewhere.”

This is making sense, but where does the stock market come in?

“I happen to know the owner here, and he went with a combination of two options. One, he got a loan from the bank. But he didn’t want to be on the hook for too much if the bar failed, and besides, the bank wouldn’t lend him much unless he had skin in the game. So he brought in an investor. The second partner put in some money, and the guy you and I know puts in the work.”

There’s that light bulb poking out.

“The two partners divide up both the assets and the cash flow proportionally to the amount of the bar that each of them owns. In other words, they split up the profits from the ordinary operations of the bar, as well as ownership of the furniture and liquor and so on in case they decide to sell any of it off, based on how much each partner owns. Similarly, if they sell the bar one day, after they pay off the bar’s debts they will split up the proceeds.”

Time to flip the switch.

“Owning stock is like being that partner. You have a claim to all of the profits and assets of the business after its debts and so forth are paid. The business can build its earning power, accumulate assets, and become an attractive candidate for bigger businesses to buy up, and in all of those cases your stock in the company can put profits in your pocket. People buy stock to participate in those profit opportunities, and the price increases as people think that the potential profits are worth more.”

But the investor dealt directly with the guy who runs the company. On the stock market we don’t buy shares straight from the company, do we?

“The company gets cash directly whenever it offers new stock. Investment banks help it place that new stock with investors. But the people who own stock may want to sell it, which is where the secondary market comes in. That’s where Mom & Pop and mutual funds and so on all meet up to buy and sell the stock that has already been issued. It’s just the same as if the investor in this bar sold his stake in the bar to somebody else.”

Now we bring it home.

“You buy stock to get a claim on the business, and you sell when you are willing to give up that claim in exchange for cash. When people think think the stock will produce greater value than the cash they’re sitting on, and they act on that conviction by buying up stock, the price of the stock rises. And vice-versa with selling.”

At this point we can answer the question robustly:

Imagine the bar’s investor put in $150k originally and got 50% of the bar. Say he owns it for ten years, and the business is really successful during that time. For one, he’s pulling out profits, so he’s probably already gotten more than his $150k back — if he sells his part of the bar, anything he gets is pure profit. For another, the bar has probably built up some assets during that time. It might have bought the building it’s in, and his part of the building may now be worth more than his original investment.

So not only has he been paid back through cash distributions, but his ownership stake has increased in hard value because of the equity they’ve got in the building. No matter where he sells it he profits, and in fact he may well sell it for more than he put in originally.

And there’s no reason to think the next investor can’t profit, too. If the bar just keeps pace the cash distributions will keep coming and the bar will eventually own the building outright. Or maybe they expand, add food service, or open a second location, and their profits increase. Everyone can keep seeing their money increase over and over, so long as the business keeps succeeding.

It’s the same with the stock market. So long as the businesses keep succeeding, stocks can keep increasing in value without anybody losing that money. The profits in your pocket come ultimately not from the losses of other market participants but from the value created by the companies. Yes, other market participants may not make as much profit as they otherwise might — that’s where your profit comes in — but that’s a loss of opportunity, not a loss of cash. Companies get capital (cash) to fund their business plans. Investors get to participate in their business success. It really can be a win-win.

Does trading on the secondary market have any positive impact on businesses?

To this point we’ve focused on stockholders, as we’re answering whether stock market profits must come out of somebody else’s losses. The answer is no, because stockholder profits can come out of the successes of the businesses whose stocks they own, just as two partners who own a bar together can profit from the success of the bar. Value creation is a real thing, and the stock market is a way for investors to participate in the value creation of listed companies.

And now we’re asking about how trading on the stock market affects companies themselves. Don’t they just issue their stock and get cash one time, while afterwards any value produced by the stock is just profit to stockholders, not value to the company? On one level that’s true, because we’re just shifting around owners. For instance, if I have a dry cleaning store and pass it on to my son, the business hasn’t experienced any benefit; it’s just a change in ownership. My son may run it better than I did, sure, but that’s because he took over the operations of the company, not because he now owns it.

The ultimate answer is yes, on the whole companies do benefit when their stocks do well. Most successful companies issue more stock to get more cash lots of times, and that becomes cheaper and easier with good stock performance. The quality of the financing available to them improves. Their executives and boards are likely to keep their jobs (stockholders vote.) They are protected against hostile takeovers. Employees with stock/options see profits, and it’s cheaper and easier to give stock/options as an employee benefit. The company’s reputation improves among vendors, customers, and potential recruits. Another company may be acquired by a stock deal more cheaply and easily. It raises morale across the organization. All of these are great for a company.

Do middlemen in the market provide value?Everybody has seen a new headline or heard a blurb on television about computerized trading groups that buy and sell stocks with nanosecond precision. This is called HFT. (Note: I do not and have never worked for an HFT firm.) To address this, let’s bracket out the details and talk big picture. After all, if you were to tell me about Netflix recommendations you wouldn’t start with the sophisticated machine learning systems that make it work, you would start by telling me that it helps predict what movies and television show I will enjoy.

Yes, some HFT firms have engaged in theft. That does not produce value and it does profit exclusively at others’ expense. It has led to prosecution, fines, and profit disgorgement, just as it should in any industry where theft occurs. I watch the market trade very closely, every single day, and I can promise you that this is not what most HFT dollars are doing. Instead, they are middlemen, performing a function called market-making in technical parlance. The last generation of middlemen were called Specialists. They received special privileges from regulators. This generation is called HFT. Specialists died out because HFTs do a better job.

Okay, so they’re middlemen. What do they do?They help the market run smoothly. Again, I can go into details elsewhere, but basically they are Uber for the stock market. You might negotiate a better rate if you find a driver and coordinate a ride, but Uber will make everything go much more smoothly. Market-makers basically do that for the stock market, by being ready to buy or sell in a stock at a given time. When you want to buy, you don’t have to cross your fingers that somebody else wants to sell the same number of shares at the same price. The middlemen will sell to you, then eventually they will find that seller. You unload all the demands of that uncertainty on the middlemen, usually in exchange for a fraction of a penny per share.

So, do middlemen in the market provide value?Clearly, they aren’t the ones creating business profits, just as Uber isn’t the one giving you a ride. Nonetheless, Uber did contribute to your transportation by helping you arrange a ride. Market-makers contribute to stock market participation in business success not by creating business success but by supporting the stock markets themselves. And their value is quantifiable, by the way: their revenues are about 80% lower than the revenues of regulator-privileged Specialists were, so clearly they’re doing a decent job.

Do all market participants have this mindset?Clearly not, otherwise there wouldn’t be so many upvotes on this answer! But not understanding something doesn’t necessarily change the underlying reality. We got sick from germs before the germ theory of disease explained it. And we had some sense of the true nature of disease — we tried to drink clean water and so on — just as my grandfather bought a lot of stock in the company he worked for because he thought it was a good company, so he had some sense of the nature of markets. For that matter, CNBC and Jim Cramer’s Mad Money couldn’t be successful if people didn’t have some sense that stock performance results from business performance.

Now, could people misunderstand the nature of markets so severely that they could harm the proper functioning of markets? Certainly. After all, a wrong understanding of disease led to the use of leeches, which were often quite harmful; the same can happen in the stock market. The great thing about markets is that when enough people really mess up prices, there’s a huge opportunity for those who do understand markets well to make a bunch of money, by pushing prices back where they belong. At some point even the companies themselves could greatly benefit, whether by buying their own shares back if the price were too low or selling more shares if the price were too high.

This gets us to a broader point: What we’re laying out in this answer is a big picture of how the market works, but not every market participant has the same role. You don’t have to understand how Elon Musk’s entire empire works to be an effective Tesla employee. In fact, you might be totally wrong about the big picture while still being a great employee who contributes a lot to the success of the organization. In the same way, various stock market participants play different roles in how the stock market functions, and they may well understand what they and others are doing in totally different ways from each other, even if the big picture I’ve described is the whole that emerges from these disparate parts:

The stock market is a place where investors can participate in the successes of business, just as the owners of a bar can participate in the success of their business.

Where did the dollars come from?After all, if I buy $1,000 of stock and sell it to you next year for $1,500, the extra $500 came from somewhere — isn’t that a loss of money for you? Well, how did you get that money? Let’s keep it simple and say that it came out of your paycheck. You created value for somebody by working for them, which you gave in exchange for money. Then you and I exchanged your money for my stock. It would have been terribly unwieldy for you to come work for me in exchange for my stock, so instead we used money as a medium of exchange. (God bless middlemen!) And where did you get the work you exchanged for dollars? You created it. So you created that value. It doesn’t have to be a zero-sum game because we can all create value.