How does investing in the stock market create wealth?

Historically the securities market has outperformed other instruments.

Well, in capitalist systems, those without capital aren’t able to do much for themselves, are reviled and relegated to roles such as wage slave.

So, by having a stock market, new businesses can be invested in more readily, creating opportunities for new business growth, innovation, etc. It makes more investment capital available. Capitalist theory also scores this as a plus.

Investing doesn’t create wealth, work does. But you need lots of stuff to do work, like factories and supplies and on and on. The stock market allows you to sell part of your company for cash that allows you to buy what you need to do work and create wealth. You can also borrow money. In either case, you need people with capital to lend to you or to sell to, and stock and bond markets facilitate these transactions. On their own, they create nothing. But through markets, people can purchase companies (or small parts of them) that makes goods or provide services that people love. That’s how you create wealth.

Look this is too complex a subject to summarize in the typical three or four paragraph Fluther response but here goes, sorry if I ramble a bit.

The stock market is one of the ways that a company can obtain capital for purposes of investment in productive assets or for other corporate purposes.

It is when this capital investment creates profits that wealth is created. That wealth belongs, in theory, to the shareholders of the entity, who are the ultimate owners of the stock.

Stock market prices for shares of a company are governed by many different factors. The academics or financial professionals would tell you that the share price reflects things like the discounted value of the future stream of earnings per share, or the inherent value of the net assets of the corporation. Others will tell you that the price movement of a stock is based on a herd mentality where buyers and sellers are following market rumors or the performance of stocks in the same industry (say Exxon Mobil goes up, then BP and other oils stocks will go up too)

When the prices of a stock move up or down, then wealth “on paper” is created or lost. When the shares of stock are actually sold, then real wealth is created or lost.

As I said, this is a simplistic view of the entire process, a complete explanation would fill a textbook.

SRM

This is a pretty simple answer. The “now wealthier” woman you’ve described in your sample was made wealthier on the blood, sweat, tears, of the hard-working employees of the company that sold the stock to her. Without them—- she ain’t got nuthin’.

Depending on how much you zoom out, it really doesn’t.

As previously stated, stocks are a way for a company to get capital to do things. If they succeed, the value of the company (and therefore the value of the stocks) increases and the people who bought stocks low can sell them high and get a little something in the way of a “thanks for the loan”.

However, there is something that seems to be overlooked so far. Say the company does increase it’s value. That often means that someone else lost a bit of wealth obtaining goods/services. There is also a loss of time and effort from the efforts of the employees. Sure, it may not seem like a loss (more of an exchange… assuming the employees get paid) but it is a cost even if it’s not entirely a monetary one.

Of course, there is also stuff like speculation and other “false wealth”, but that generally leads to a bubble like the housing one that burst fairly recently so therefor I do not consider that actual wealth. Yeah, some people made millions, but millions of others lost a lot too.

True wealth cannot be created, only redistributed.

Creating wealth.

The stock prices of unsuccessful companies generally do not go up and the stock prices of successful companies do.
You can’t state that profits are made on the backs of “blood, sweat, toil and tears” of corporate employees for the benefit of greedy shareholders. Without profits there are no raises, no enhancement of insurance benefits, no overtime, reduced travel, cutbacks in hours or heaven help us, layoffs.
The profit motive is the only incentive to be in business, otherwise it is a charitable contribution by the owners of the company. If you don’t get a return on your investment, why make the investment?

Would you put $5,000 in a bank if you were not getting interest, or if you knew that you would lose five percent every year? Corporate investors take a risk on their investments in exchange for a possibility of a return that is higher than you get at the credit union. I worked for a guy who invested $3Million to buy a little company. I was hired as his Controller. We expected to lose money for the first year but make a profit after that. The owner used to quote exactly what I said above: if I can get 6% (this was 1988) at the bank why would I invest money to earn a lower return?

So profits create wealth, wealth evaporates with losses. If not for the creation of wealth, why take a risk with your money?

@srmorgan Some organizations measure return in something other than dollars though, so I think it may depend on your definition of “wealth” and “profit”. If you were correct, there never would be any such thing as charity; there would be no reason for them to exist.

But let us return to mere money. Considering that many raises (at least for many Americans) barely keep up with inflation, it’s a tricky thing to measure. Look at it this way; when I started at one particular job, I had to work for an hour just to pay for the gas I burned to get myself and my wife to work. Five years and a few raises later, I was still putting my first hour’s worth of wages in my gas tank. The price of other things went up too, so as far as real financial wealth is concerned, I wasn’t getting ahead despite earning more money.

It’s a bit more complicated than that, but you really can’t get a good grasp on it if you only look at the little picture. For instance, the company I worked for profited by taking the wealth from others, and most companies do the same. However, since we were taking wealth from Japan and bringing it to the US, it could be argued that we created wealth in America, though the truth is that we merely transferred it.

People with good ideas need money. People with extra money need money at some time in the future. They want to share the opportunities and risks when the good ideas turn into products and services. I see nothing wrong with that if it’s really about the long-term good. The trouble starts when people focus on short time goals only. Or when bubbles are being created.

@mattbrowne True, but look at our society and I think you can see where that could lead to problems. Many people are more concerned with their own personal wealth than with the greater good, and will gleefully sacrifice the future for gains in the present. Besides, consequences only happen to other people so who cares, right?

I was trained as an accountant and have worked as one for 32 years and by now I have a pretty good idea of what a profit is and what a loss is.

We were talking about the creation of wealth which is measured by monetary value. A charitable organization depends on contributions from individuals or institution. The key accounting measure in a charitable or other non-profit organization is cash-flow, cash lows in should exceed cash flows out (spending on the target of the charity: a church or synagogue, the homeless, cancer research, etc is treated as an outward flow or use of cash). The idea of a charity is NOT to earn a profit. Their objective is something altruistic, not financial.

The object of a business organization is to maximize profit, nothing else. If there is no profit or possibility of profit, the organization has no reason to exist.

When we are talking about the creation of wealth we are talking about the value of a company which accrues to its shareholders. We are not talking about salaries or benefits or corporate expenses or even capital investments by a company. The value of a company is the price that someone else would pay to purchase it, either by buying shares of stock in a public company or through a private purchase.
The value of a company increases if it is capable of making a profit or it is perceived that it will be able to make a profit in the future.
Increasing the earnings of an employee is not the creation of wealth. If the employee owns shares in a company say, through a 401k account, the employee’s wealth increases if the stock prices in his account increase. He has purchased shares at one price and now they are valued at a higher price. This is called an unrealized gain or a paper gain. If the employee sells at a profit, personal wealth is created. If he sells at a loss, wealth dissipates.

I own a house, I own shares of stock, I own some undeveloped land 25 miles from town. If the market value of my house or these shares or the land goes up, wealth (on paper) is created. If I should be fortunate enough in this economy to get a raise my INCOME goes up but wealth is measured by the net value of things that I own, not by what is on my W-2.

@jerv – If your employer was able to give a customer a better deal then the one offered by a competitor in Japan, that is just good business. It created profits for your employer and reduced profits at the competitor but the wealth of the owners changes only when the market value of the company changes. If stock prices around the world go up, then overall wealth is created. This is not a zero-sum game.

SRM

@srmorgan “Their objective is something altruistic, not financial.” So are they truly less wealthy? Actually, that’s more of a philosophical debate than an economic one so lets let that slide.

I’m still trying to wrap my head around how the stock prices can go up around the world without either a depletion of resources somewhere, the expenditure of manpower (whether intellectual or physical labor), or creating a bubble that will eventually burst.

As for your personal wealth, did that land suddenly spring into existence or was it formerly somebody else’s, in which case your net worth increased while their’s went down?

I may be looking at too big a picture, but I fail to see how it is not a zero-sum game.

I bought six acres of undeveloped land in 1999. I bought it from a family that had a much larger farm immediately next door to this lot and I believe that they had owned it for a substantial period of time, several generations.
Their wealth at the time of the purchase would have been X – the value of the land per acre times the number of acres in the parcel. That wealth would have increased or decreased as the market value of the land increased or decreased. In accounting terms we would call this an unrealized gain but in this context we are talking about value, not income.

When they sold it to me they now had $xxx,xxx in cash, $xxx,xxx in income (less their cost) but their wealth remained the same. The total value of their personal assets did not change.

Nor did mine, I paid $xxx,xxx for the land. I now have an asset worth that much. I paid 20% cash and took a 80% mortgage, so my net worth did not increase or decrease.

In the stock market when we are talking about creating wealth we are talking about increasing value of assets, not income. To go full circle, financial theory would state that the value of a stock is a reflection of the discounted value of future earnings, If earnings or profits are increasing or projected to increase then the value of the company’s shares will increase (usually) which creates market wealth.

Wealth., at least in accounting terms, is not the same as income. SEE NEXT ANSWER

I’m still trying to wrap my head around how the stock prices can go up around the world without either a depletion of resources somewhere, the expenditure of manpower (whether intellectual or physical labor), or creating a bubble that will eventually burst.

I’m sorry, I have drafted a response to this three times and I keep getting mired in accounting terminology, not economic terms. So let me try to generalize a response.

A company has a value of $1,000,000,000 based on its stock price and number of shares outstanding. The company drills for oil It produces oil to be sent to a refinery and it sells it at a price greater than the cost to produce it. It has made a profit and that profit plus future profits would be reflected in the stock price. Yes, the total number of barrels of oil in the oil field have been depleted but the act of taking the oil out of the ground and creating a profit, should, in theory, create wealth for the stockholders.

Similarly compensation is paid to the workforce that engaged in producing the profit and is part of the cost of production. Labor is expended in that production but the cost of the value is included in the cost of production.

There is a value to Human Capital but that is not quantifiable in any way, whether in economic or accounting terminology except in theory.

I am hired by a company to be Chief Financial Officer. My job is to manage the financial affairs of the company and to bust my ass doing that. How do you value me?
I am compensated for the work I do (not enough by the way). Is my annual compensation my value? I saved the company $40,000 at the end of November by re-negotiating a freight contract for 2010. That savings is realized in 2010. Is my value now my compensation plus $40,000? You can’t value me or my value to the companys because there is nothing tangible to measure except in theory.

Bubbles are created by the over-valuation of assets. The tulip bubble in Holland that is used as an example was caused by an hysterical overvaluation of tulip bulbs. The mob mentality had people speculating on the prices of assets which had no relationship to the intrinsic value of the assets, in this case flowers. When the market corrected itself (came to its senses) people who had overpaid for the bulbs got wiped out. They speculated and lost. Sometimes you speculate and lose. The growth of the bubble created wealth as it increased. If I was smart enough to get out ‘when the getting was good” then I am wealthy cause I now have an asset (cash) that will not lose its value as opposed to an asset (tulips) that will collapse in value. The bubble creates value and then is deflated and wealth is lost.

I am running on and on here. I hope my responses are coherent and helpful.

SRM

@srmorgan I am very happy to read your thoughts on the matter. Thank you for taking the time to go over it. Allow me to try to summarize what you’ve stated in response to my initial question and also follow the logical conclusion of that summary. Then I have some questions.

Paraphrased summary:
With regard to the creation of wealth (for a nation’s economy) the stock market provides capital for companies that can then leverage that capital to produce profits. The act of producing profits is the creation of wealth even if it relies on human capital or natural resources. The reason the stock market provides capital efficiently is because investors also have the opportunity to realize profits by trading their shares on the market. This also has the benefit of providing competition between companies for capital on the market, which in a free market would be the most efficient allocation of capital. Is this correct?

If so, I have two more questions:

1) When an investor realizes her gain by selling her shares for a profit, is this the creation of wealth? In other words, assuming there is no over-valuation bubble, are the profits from the wealth generated by the company? Or just from another investor who is paying into a system hoping to make profit later?

2) How can the use of natural resources be considered the creation of wealth if they are consumed in the process? Wouldn’t the wealth of the nation be better summed as available resources plus wealth generated by companies? (Foreign policy throughout history would seem to indicate that leaders have believed this). The reason I think this is because if the resources are used up (to simplify the case of them becoming more expensive to procure), then there is no more potential for that company to profit and thus no more potential for wealth to be generated. Furthermore, any other company doing similar business on an island where all resources are used up will now be out of business or need to restructure their operations.

This second question has really interesting implications for the future of capitalism. It seems to me that the entire system is based on the capacity for growth. Large growth means large profits, small growth means smaller profits. But this growth appears to depend on resources in the end and we are actually approaching an era where some resources may no longer be economically available (oil, phosphate ore, etc.).

I guess this raises a third question…

3) Can an economy based on capitalism survive without positive growth? This is an extraordinarily important thing to understand, in my opinion. Human civilization has been characterized by explosive growth in population and technology, but we appear to be approaching the end of the planet’s capability to support this population and technology (based on the reports I’ve read recently discussing the future scarcity of food and fresh water resources, climate change based on CO2 concentrations, peak oil and peak phosphate). We can debate about how much time that will take (some say 50 years, some perhaps hundreds of years), but the real issue is ecology. It’s thermodynamically not possible to sustain exponential growth in an essentially closed system (one could argue that the sun provides input to the system but since we are not plants we rely on more inputs than this). Therefore, growth is better modeled as logistic, a sigmoid curve. But can a capitalist economy survive logistic growth?

I’d like to stress that I’m not arguing for or against capitalism. I recognize it has pros and cons. I am approaching this like Plato in The Republic. What is the truth of the matter?

@srmorgan -“There is a value to Human Capital but that is not quantifiable in any way, whether in economic or accounting terminology except in theory.” I think that that is where I am having the most difficulty. If nothing else, how can you really judge the value of a person without knowing how long they will continue to be productive etcetera, so any value you did place on a person would be speculative anyways.

At a glance, it seems to me that the economy in general has been based more on speculation than anything of real substance. Then there was the “fun” caused by misinterpretation of the Gaussian Copula

As for your questions, let me give you my take on them.

1) Any increase in the stock value is a result of an increase in the value of the company issuing the stocks, whether that value increase is the result of the company doing a good job at providing (and thus getting paid for) providing goods/services or merely the result of having a higher net worth due to having more investors donating to their coffers. How the company increases it’s value is (in my mind) rather irrelevant.

2) Thus the TANSTAAFL principle. Now, how much is it worth to move 23 miles through the city without walking? For me, it’s about $2.89 and the slight dread of knowing that gas won’t be available forever (though it likely won’t run out in my lifetime, and yes, my Toyota doesn’ t have the greatest city MPG either).
Now, how do we define “available resources”? Is oil that you can’t drill for in a cost-effective manner truly “available”? I mean, some reserves would require extra refining to be usable while others would cost you more in security than the oil itself is worth.
The lumber industry generally realizes this and thus they now plant new trees, limit their clear-cutting operations, and thus give themselves something to do a few years down the road; they restructured their operation and sacrificed a little short-term profit to ensure long-term sustainability.
Unfortunately, there are many people that combine short-sightedness, greed, naivety, and nihilism in ways that may earn them a quick buck. Lie I said before, consequences only happen to other people ;)

3) My wife needs the computer now, but read this article and tell me what you think afterwards.

Later…

“There is a value to Human Capital but that is not quantifiable in any way, whether in economic or accounting terminology except in theory.” I think that that is where I am having the most difficulty. If nothing else, how can you really judge the value of a person without knowing how long they will continue to be productive etcetera, so any value you did place on a person would be speculative anyways.

@jerv I am not sure what you are getting at unless you are completing agreeing with my point. You can not come up with a fixed number that represents the value of a single person. I am 60 years old. Most people would retire at 65 and I have five years of productive work left for this company. You can’t put a $ sign on that value. Last year I had to have a pacemaker put in which restricted my future travel and has me considering an earlier retirement. Has my value to the corporation changed? You can’t put a number on this stuff.
Companies like to talk about the value of the Human Capital but this value is so abstract and unmeasurable, it is just corporate speak. Meaningless.

Thank for the reference to the Gaussian Copula. I have never dealt with anything as complex as what is shown in the article but apparently I retained a good part of what I learned in Advanced Statistics in graduate school to follow the logic up to a point

But the essence of the bubble was that we had a lot of very smart men and women listening to other smart men and women who read about other smart men and women who also ignored the fact that the data and the means to evaluate the data was, at heart, faulty and flimsy. It is as if half the industry bet on red, half bet on black and seemed very surprised when zero and double zero kept coming up.

1) If investors add more to a company’s coffers, say by buying newly issued stock, this does not increase the net worth of the company, at least not from an accounting standpoint. Issuance of stock increases cash and increases equity. Net worth remains the same. A share may rise or fall in value for any number of reasons: earnings are the most likely reason but it could change based on new products coming to market or competitors catching up to you or having Tiger Woods as your only spokesman.
But you are spot on by saying that “how a company increases its value is ..l rather irrelevant. If I own 100 shares of Exxon Mobil and the stock goes up 10% I could care less why it happened.

2) Again I am coming from an accounting background, that is how I was trained. I merely tried to use the exploitation and depletion of oil as an example to support my statements about how profits, and ultimately, wealth is created. Managing natural resources for the future or how we are going to bring scarce resources to market has nothing to do with how ‘wealth” is created. Two different points I think..

TANSTAAFL – I learned that a long time ago, but I am having great difficulty explaining this concept to my sons, 21 and 19, who can not seem to grasp the idea of who is actually paying for that “Free CD” that came in Guitar Hero box.

3) I understand your spousal predicament.Been there. Bought her her own laptop two years ago for Valentine’s Day. Better than any amount of flowers or chocolate
Interesting article. One thing that came to me was the similarity of behavior by seemingly knowledgeable people in different contexts. Simon is fighting against a “Chicken Little- the sky is falling” attitude that has become more and more prevalent since Ehrlich’s original publications (I was in college in 1968 and I remember a lot of people espousing Malthusian theory when we were sitting around discussing how scary the future was) and fighting with a great deal of people who seem to have forgotten “The Emperor’s New Clothes”
If a trader or a quant on Wall Street pointed out an error in the data underlying Li’s theorem or other flaw in the reasoning, he was ignored because this conflicted with the conventional wisdom that everything was going fine and we are going to make a ton of money.
I have sat in corporate meetings wanting to scream how what I was hearing was wrong, just plain bad assumptions using incorrectly structured empirical data but I had to shut up because it wasn’t my place upset the apple cart. You have to “work through channels”. When I started at my last job one key point made to the accounting and IT staff was that I wanted to be told if I was wrong about something and that meetings were open for all to contribute opinions. Sometimes my dumb idea is what went down because I was responsible for a financial or IT project and if it was going to be my butt on the line then it was my decision. But there were enough times where I was helped NOT to make a big mistake by someone invited to sit at that conference table.

There is a big difference between theory and fact. Thanks for the Simon article.

SRM

@srmorgan I pretty much am agreeing with you. And the part I am confused by is how you can really based anything concrete on a total unknown. I mean, how can you do a cost/benefit analysis if you can’t figure out either side?

Re: TANSTAAFL – I learned the difference between “free” and “included” before they were born. Most Linux users who buy (as opposed to build) a system likewise know since Windows jacks the price up considerably and occasionally provokes lawsuits demanding a refund for a product that was paid for but not wanted nor used.

Re: Gaussian Copula – If Li points out the flaws and limitations of the equation then that should be enough reason to not trust it… or is that just too much common sense?

Re: Doomslayer – Bah! Who needs facts? They just get in the way :)

Some times it takes a dumb guy to give a straight answer.

Stock markets produce wealth this way.

1) make money selling stocks – OK that’s a no-brainer
2) put unused (saved) money to work… this is more important. Its why capitalism kicks ass.

ever hear it takes money to make money.

When a company goes public it sell shares of itself. This generates money that is used to buy stuff the company needs. It’s like a loan (but it’s different).

This allows the company to grow, and provide service, better to more people. The company is worth more, and the value of the shares rise.

This generates wealth for investors (stock holders), owners who sold shares, and generates jobs. A growing company needs more workers.

On paper this is great, but it fails as often as it works – hence risk. It can be corrupt depending on the players.

Sorry, I failed at keeping it brief.

@DrMC I think that that second-to-last paragraph illustrates the problems inherent in the system. It’s those differences between theory and practice that lead me to many arguments with Conservatives.
BTW – When do we get to the job-generating phase of our recovery? I mean, with all of these companies turning around, the economy on the mend, and the CEOs raking in the dough, you’d think there would be a little more job creation going on unless (once again) reality is not conforming to theory.

Hehehe I kept it brief by keeping politics out of it. The question itself warrants the most direct answer.

Once you have the ABC’s down, then pack in the partisan spin.

Any system, right, left up, down, green red or purple succeeds on the backs of its…
workers
leaders
fathers
mothers
school teachers.

The best reference of all I could point to is this one:

“Eat The Rich”

http://www.amazon.com/Eat-Rich-Treatise-Economics-ORourke/dp/0871137607/ref=sr_1_1?ie=UTF8&s=books&qid=1262030172&sr=1-1

Ethics are the fuel and lubricant of any system. Capitalism failed Albania, but worked most effectively in Hong Kong.

Socialism struck out in Russia, but excels in Scandinavian countries.

The difference. The people.

All there, all deserving credit.

All systems have problems, all games can be cheated at. Why play with a bunch of cheaters?

The first system that worked ever needs to be re-examined. The family unit.

A prominent black physician once told me her theory about inner-city morals. In slavery we chopped off the family and tribe, destroying the traditional continuity of ethics.

An excellent model of what modern society is delivering to you today.

I wonder what will fill the void? The State?

Hail the Anointed One, but be careful. Big Brother is Watching.

@DrMC Greed is good:

@jerv – I’m not saying it never leads to problems. I’m just saying, in principle it’s a good idea. Trade is a good idea too and homo sapiens eventually discovered its benefits. This doesn’t mean trade cannot create problems.

@mattbrowne Honestly, I don’t see many things causing problems in principle. What I see is people causing problems and using many ways to do so ;)

greed – unbridled motivation at the expense of functional values (stab your best friend in the back, steal his job and take his wife) – can be bad.

Motivation good.
Bad values and actions: bad.
Barney and mister rogers: satan

In simple terms, the money you invest in a business (and let’s say that you buy the stock as an IPO) is used by the business to grow itself. That is, the company invests in plant, equipment, labor and technology to make and sell a product or service. You certainly understand that.

The business, if it will be successful, has to earn a profit, which it annually either returns to the stockholders in the form of dividends, or retains and puts back into further investment (probably in itself, but not necessarily—the business can make its own outside investments), or some combination of dividend return and retained earnings. Since most business owners are reluctant to give up control of their companies, the owners (or ‘the business itself’) retains a large portion of its stock for themselves.

Over time, the company continues to expand, modernize, re-invest and make more profit, and the compounding of that growth and profit can make even small companies into quite large companies, even if they don’t have the wild success of a Microsoft or Google, to name a couple of recent ‘wild successes’. (Note that we haven’t yet discussed the trading of that IPO that the original investor purchased.)

As this growth of the company occurs, since it is a public company, the facts of the growth are available knowledge to any potential investor, which is why the value of the stock fluctuates over time. Investors recognize the utility of the company’s products and services compared to their competitors and compared to what the market “needs” from time to time and bid the stock up or down accordingly.

So in terms of your example, if the stock has doubled in value over 5 years, then that is because the market has apparently viewed the stock (that is, the company whose fractional ownership is represented by the individual shares) is worth twice as much as it was on the day she bought it. There’s no telling what will happen to the next investor; that depends on the company’s management, its products, and to the overall economy in which it operates. But on the day of the sale at $2000, “the investing world at large” has set a value of twice the original investor’s stake.

To answer one of your later questions in the thread, the value has been created over the entire 5 years, not just when the stock is sold. (That is also true even if shares are never sold; the ‘value’ is there; it’s available as collateral for loans and for determining one’s own net worth, for example.) That value is “realized” or cemented, when the stock is sold, but the value is there every day that the stock is owned.

I didn’t want to get into such a lengthy explanation of your question on “natural resources”, but I will say that “undeveloped” natural resources are merely potential, and not actual value. For example, there’s probably more oil in the deep seabeds than we can even imagine, but for now it’s essentially useless, because no one has the technology (or the means of establishing ownership rights) for mid-ocean drilling.