Re: Market efficiency: good or bad?
Sat, 3 Jul 1999 14:38 +0000

Okay, I'm harping a bit, but let's go over this logic if you don't mind; I didn't ever respond to the original post.

>Eliezer S. Yudkowsky wrote:
>> Brian Atkins wrote:
>> >
>> > Are you saying the "market efficiency", helped by day traders,
>> > is a bad thing?
>> Yep. You've got people buying a stock because they think other people
>> will buy the stock because other people... it doesn't ground. You've
>> got massive, volatile, pointless movements materializing out of nowhere.

Not really out of nowhere. People buy stocks because they expect them to go up in value, regardless of whether they buy them from the corporation that issues them or in the stock market. Second point, it does ground eventually. At some point the expectation that the stock price will continue to go up fizzles out, and the price does stop going up. It's utterly -- ultimately, in fact -- rational.

>> What I'm saying is that people who want to bet on stocks should bet on
>> stocks, and people who want to give money to people who can use it to
>> make more money, should give money to people who can use it to make more
>> money. The "growth stock" is a cruel joke that will eventually be the
>> downfall of Western Civilization if Zyvex and I don't get to it first.
>> You can quote me on it.

It sounds like you're saying there should be a division between what's called the primary market, where people buy stocks from corporates, and the secondary market, where people buy stocks from each other. But since the two prices are always equal, making this division fails to reward the investor in the primary market, since he can't sell his stock on.

>> A high-computing-power capitalist economy can get along perfectly fine
>> even if there is no stock market whatsoever. I give money to someone,
>> they use it to build a new manufacturing plant, and in exchange I get a
>> percentage of the dividends from that plant - that's my "stock".

Yes. Forever. And that's all you ever get for your investment -- a stream of dividends. But surely that expected stream of dividends is worth something today, and you may need the cash today rather than waiting for your two bucks a share a year forever. What would you pay me if I promised to pay you two bucks a year forever? Whatever figure you put on it, imagine someone comes up to you and offers a dollar more for the right to receive those dividends instead of you. Would you sell if you could? Of course you would. What you're suggesting translates to forbidding that transaction.

>> When
>> the manufacturing plant shuts down, the dividends stop. If they managed
>> to generate enough revenue, I make a profit. If not, not. No
>> information loss, and when I want my money to make money, I actually
>> give it to people who will use it to make money, not to the previous
>> investor who buys a speedboat.

But Elizier, the reason he can buy a speedboat is because he assumed the risk that the company wouldn't be able to keep up its stream of dividends. It turned out they could, and the value of the stock rose, and he sold it at a higher price than he bought it for. He was rewarded for taking the risk. And that's all to the good -- in fact that's the essence of capitalism, assuming the risk on behalf of someone else.

What you may be chafing at is the idea that stock prices move out of line with what you can expect to be rewarded with for the risks you're taking. We call that a bubble, and I posted on that yesterday, so I won't bore you. But the thing to remember is that those day traders are still taking the risk, though they may have forgotten that point. If they're holding the stock and they turn out wrong, they'll still suffer the losses.

>> In practice, you would quickly get a market in stocks, and people would
>> buy stocks from one another based on how they think the future is going
>> to work out, and eventually you would get people buying "growth stocks"
>> again. I'm just pointing out that shuttling all the day traders into
>> actual casinos isn't going to hurt the economy. Nor would creating an
>> enormously higher rate of actual capital investment (so that the money
>> now flooding into the stock market would go to buy actual machinery
>> instead of speedboats) kill the market by flooding it with new stocks.

So if the secondary market is moved off of the stock exchanges and into the casinos, it's no longer a stock market? What exactly does that do that's any different from what happens on the exchanges now? Well, unless the regulations for trading at the casino are as strict as they are for trading on the exchanges now, it makes for more opportunity for insider trading, and increases the volatility. The participants will be the same: they can no longer get what they want on the exchanges, so they'll just move to the casinos. This will become the new market, and it'll be the same as or worse than what we have now.

>> In other words, there are three elements in the modern market:
>> 1) The person with money, who wants to turn that money into more money,
>> by giving it to someone who will produce wealth. Presently filled by
>> venture capitalists.

...and institutional investors. Don't forget them. Mutual funds, pension funds, insurance companies. Fidelity, Dreyfus, Robertson Stevens. Big-time money. The backbone of the global capital market. The real market movers, the guys who bet $50m at a shot.

Yes, venture capitalists are there. But venture capitalists are like 10% of the money. They expect to profit by selling to the institutions in a primary offering, an IPO. They skim off the top. They never expect to hold stock for the long term.

>> 2) The person who thinks he sees a piece of property, such as the right
>> to receive a certain percentage of dividends, which is undervalued.
>> Presently filled by small investors.

...and institutions, once again. Here, though, add hedge funds. These are the guys who I think have gotten up your nose. All they do is play the volatility in the secondary market. The problem in isolating them, though, is that the only difference between them and a small investor is size. They do it with bigger money. But how are you going to regulate that??

>> 3) People who think they know which way the market will go and are
>> willing to bet on it. Presently filled by day traders.

...who by and large take a 25 cent per share profit when they can get it. These guys are small potatoes. They're the lubrication to the whole process.

>> Right now, the stock market is a mess. The first problem is that most
>> small investors want to do (1), a positive-sum game, but are stuck with
>> (2), a zero-sum game; and the second problem is that the people doing
>> (3), a _highly volatile_, mathematically chaotic zero-sum game, are
>> forced to buy actual stocks in the same market as (1) and (2).

No, no, no. It's a positive-sum game for all of them. Mostly these guys aren't geniuses or rocket scientists. If it were zero-sum, market factors would have generated insufficient profits for them to continue to exist.

>> What we need is, (a) actual market-gambling casinos; (b) some way for
>> small guys to join venture-capital cooperatives. That'll go a *long*
>> way towards untangling the unholy mess.

All market-gambling casinos do is to move some of the players from one locale to another. And since if prices diverge that creates an arbitrage opportunity between the markets, the two prices will have to converge and it will accomplish nothing.

As to your second point, there are mutual funds set up expressly for this purpose. Dozens of them, in fact.

>What we have now is a vast pyramid scheme, which has not yet
>collapsed. The value of the stocks continues to climb
>because each buyer is borrowing against the future, betting
>that she can get out with her dough before the whole thing

People are buying stocks because the present value of the stream of dividends they expect to receive in the future from owning them is greater than the cost of buying the stock now. They may not make that calculation in their heads all the time, but that's what's implicit in the stock price.

And I also take the point that many investors think someone else may have a higher number in their heads than they do, and buy so they can sell to that guy. This is called the "greater fool theory," for obvious reasons. But what if that guy is right? What if we've sold a stock at a price below the present value of the expected stream of dividends? What if the internet really will supplant all other commerce and it'll be funneled through these trunk-lines? Won't you feel like an idiot having sold at half the true value of the thing?

>> I'm not suggesting any form of government mandate; I think that the
>> natural efficiencies of doing The Right Thing will attract people into
>> separate markets along the lines I suggest.
>Are you joking?

Actually, I have to echo this. The Right Thing doesn't carry a very high price tag in the real world. The volatility arises due to a common utility function, which states that more is always preferable to less. People will always go for more money over less, and anything that supports that principle will be rewarded.

>> Once again: Almost all really complicated economic problems are the
>> results of combining multiple functions into a monolithic object.

Sure, but so what? They're still complex, and as such won't respond as expected to simple solutions.

Volatility occurs as a result of the globslisation of the capital markets, which serves very useful functions elsewhere. Call it a side-effect if you will. It won't go away with the addition of another palliative. My advice is get used to it.