Friday, October 22, 2010

Warning: Don't believe any of this:

To begin, let me clarify the fact that I have absolutely no authority to speak about the stock market. I have not studied it, participated in it, or bothered much to care about it. The following (and prior) ideas are my own, and should therefore be heavily scrutinized. I haven’t really thought about any of this prior to yesterday, so feel free to pick it apart. That said, here is a reiteration of what I was trying to say last night.

The stock market is like a bookie. If you would like to bet on the winner of a football game, you either have to pay odds, or you bet the line. The line is an interesting concept, basically you place your bet on which “side” of the line you like. If you think the Seahawks will win by more than 3 points, you put your money on that side. How that line is established is by the bettors actions. If too many people like the Seahawks minus 3, the bookie will shift the line to minus 4 or maybe 5. How does he decide where to set it? …equilibrium. When there is equal money on each side of the line, it is properly established. This means that all the losers pay all the winners and the bookie collects a fee from the winners (the vig or juice). This is the same thing that the stock market is doing. The constantly changing, opposing pressures of wanting to sell and wanting to buy at any price, move the price such that it is equal and the broker collects a fee. Truly a zero sum (negative sum if you count the fee).

Let’s look at this from another angle. If a trade is said to be positive sum, both parties must be better off as a result of the trade than if the trade had not occurred. Even though the stock is increasing in value, the beneficiary is the holder of the stock. Had the trade not occurred, the seller would have that additional value. So, the same amount of net value is created with or without the trade. The trade doesn’t create value, it transfers it.

Here’s where it gets a little dicey and what kept me up all night. When the trade occurred, both parties believed they were getting a good deal. At the surface, this appears to be a positive sum. But remember that the value they are attaching to the trade is based on expectation of a future event. Maybe an illustration will help. Say you buy an apple from a fruit stand. Since this was a voluntary exchange, we know that both parties are better off…right? Well, what happens when you get home and bite into that apple? Your decision on the purchase (which is now a sunk cost) was based on your expected “utility” from eating eat. If when you bite into the apple, you also bite into a worm, how does that change your utility? It turns out that your net gain from the exchange is the total benefit you actually receive minus the total costs you actually paid. We can now look back in time and see that you made an “irrational” decision, because of imperfect information. If you’re buying this, look back at the stock market example again. The actual net benefit from the exchange of the stock is exactly zero.

Finally, what about time preference, present value bias, future discounting or liquidity value? I contend those all are essentially the same thing. This is the very tough to handle idea of a person knowing that the stock is going to increase but selling anyways; something that happens quite a bit (and was captured in the earlier example). The reason this is difficult is that it suggests that a person can generate a different utility value for money itself, the unit of measure we use as a metric for utility. I am not going to try to argue that this is not true, but I am going to say that the result is inconclusive. Josh’s “imaginary poverty” will help out here. Remember that for a transaction to have a positive sum, both parties must be better off as a result of the trade. It is not possible to determine if the net is positive when one person gains and the other one loses because of the ordinal and unique nature of utility. So, if we are to say that the result of the trade is undoubtedly positive, both individual utility levels must rise relative to the trade not happening. We have to compare the utility level of each individual at the point of the transaction versus the same point in time in the future in both possible planes of existence (with the trade versus without it). Then, the trade has to generate more utility than the not-trade. Since it is clearly impossible to evaluate the two situations after the full effects are known, not based on the expectations of the future, we cannot know if the person is actually better off. So, although it may be possible to conceive such a case where the trade itself creates a utility increase (but not a monetary one), the actual analysis is indeterminate.

Oh, I should probably clean up on more issue. The stock itself is a financial instrument. Any “value” it has is captured by its price. It has no flavor, aroma, shimmer, melody or texture. There is no consumption value, only value in trade.

Thanks for your time.

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