12. Pseudo-investment 3: (Most) Share Dealing

People may be surprised at seeing share dealing listed under the heading of pseudo-investments. There is a general perception that trading stocks and shares is simply an indirect mechanism for investing in companies. However, more than 99% of share dealing transactions give no benefit whatsoever to the company whose shares are being traded. It is true that when a company issues shares and they are purchased in the first instance (a so-called Initial Public Offering or IPO) the money paid goes directly to the company and so may be used for productive investment. However, if and when company shares get sold on in the so-called secondary market, possibly a great many times, none of the subsequent selling price goes to the company, even if the price of the shares soars.

Many people argue that the fact that shares are allowed to be sold on and traded means that the initial purchasers (the people who buy the IPOs) will be willing to pay a higher price than would be the case if subsequent trades were discouraged or not allowed. Therefore, they argue, a free and enthusiastic secondary share-dealing market is an essential part of investing in business. In this chapter we will argue that this claim, while true, is rather overstating the case. There are indeed some advantages of having a secondary market in shares, but allowing this market to be entirely unrestricted leads to some truly awful consequences which have been overlooked by most economists. In this section we intend to show that the benefits of an entirely unrestricted secondary market are small and the problems caused are very large indeed.

Initial share sales (this is the good bit that works)

At the most fundamental level, the reason people buy shares is for the collection of dividend payments. If an individual or a bank has some cash they want to invest and earn money with, they can examine the prospectuses of the latest companies that are in the process of issuing shares and choose one or more which they believe will be most profitable and be able to pay high dividends. This is true investment, the way it is supposed to be: Skilled investors, able to spot a good business plan, guiding resources toward companies that are most likely to prosper. These kinds of investors are performing a function that is of benefit to society. The more skilled they are, the better society’s resources will be guided. There will be less wasted effort on poorly thought out business plans. If these investors get it right then the rewards will be great, both for the investors themselves and for society as a whole. If one of the companies they have shares in makes good profits then the investors will start collecting large dividend payments.

A company can only be successful if it’s making something that people want, either something that was previously unavailable or perhaps something that is better or cheaper than the existing competition. This is a win-win situation for the shareholders and the public. The free market is working. Adam Smith’s “invisible hand” is doing its job perfectly. The selfish acts of the investors for their own personal reward serve to benefit society as a whole through new, better or cheaper goods.

Unrestricted secondary share dealing and price accuracy

It is very likely that some people reading this will be thinking that the assumption that people should buy shares for dividend payments is wrong. They will point out that many people buy shares largely because they think the price of the shares will rise. They think that the profit they can make from a rising share price is more significant than any dividend payments that they could get from owning shares for a short period. In this section we will examine the practice of buying and selling shares over short periods with an aim to making money primarily from changes in the price rather than from dividend payments.

If you were considering whether or not to buy some shares and hold on to them forever and benefit purely from dividend payments then you have some obvious business-related problems to solve, i.e. what is your expectation of future dividends and does the price of the shares represent good value for this future income stream. This will depend on how well run the company is, the size of the potential market for the company’s products, what its competition is like etc. etc. One thing you don’t have to think about is how valuable other share traders think the shares are. If you are correct in your estimate of future dividend payments and you think the shares represent good value while the other traders incorrectly think that future dividend payments will be poor, then you can just snap up the bargain shares and then later sit on your deckchair on the beach sipping Martinis and enjoy your large dividend payments forever more. You can occasionally have a chuckle to yourself about how wrong everyone else was.

If you are going to hold on to shares forever then the only things you need to consider are the price and your estimate of future dividend payments. You do not need to consider the opinions of other share dealers.

Contrast this share purchase decision to that when your plan is to only own shares for a short period. Suddenly the opinion of everyone else becomes critical. To see why this is so, consider the following tale:

Short-term share dealing

Imagine we have dealer called Harry. He has been instructed to buy and sell company shares within one working day and maximise his profit. This scenario is actually so commonly practiced that it even has its own name: day trading. Let’s consider what Harry needs to think about in order to maximise his profits. Let’s say for a moment that Harry is super-expert in business plans and company valuations. It’s his first day on the job. He (perhaps naively) assumes that what he needs to do is find shares that are cheap, buy them in the morning, then sell them in the evening when their price may have risen a small fraction. Harry starts some laborious, painstaking research and according to his calculations of expected future dividend payments shares in Company X should be worth $10 each. But Harry notes that they have been trading steadily at around $12 for months. What is he to think? Is it him who’s wrong or is it the other market participants? Let’s say for a moment that he concludes that he is right and its everyone else who’s wrong, either because he thinks that he is smarter than the average trader, or perhaps because he can see an explanation for a share to be overpriced that he suspects other people have not taken into consideration – something about Company X that looks superficially good but when analysed more carefully or with Harry’s specialist expertise, is not so exciting after all. Harry may consider that, assuming that he is right, in the very long term the existing share owners will see that the dividend payments (which are generally infrequent) are on the small side considering the price of the shares. They will eventually see that the shares represent a poor return on investment. So he may say to himself that the long-term outlook for the price of those shares is negative, though the downward correction to the share price might only occur many months or even years into the future. There is always that tiny risk that the downward correction could happen during that day so he feels generally disinclined to buy these shares.

So far his investigations have come to nothing: He has not found a good money-making opportunity.

The early news trick

Suddenly the phone rings. On the other end of the line is his trusted friend Bob. Bob mixes in high circles and is usually among the first to know about all sorts of political and high finance gossip. Bob tells Harry that he thinks there is going to be some changes in the tax system which will have an impact on Company X. It’s an easy calculation to see that Company X will be able to make 1% greater profits than before and so the true value of its shares will rise (by his calculations) from to $10.00 to $10.10 per share. Bob also knows that the official news about the new regulations will be broadcast at lunchtime and everyone in the market will find out about it then.

What should Harry do with this information? His initial thought is that even with an expected future dividend stream that is 1% higher, the stock will still be poor value if trading at $12. So its long-term outlook is still negative and he should still not buy shares in Company X. But then if he thinks a little bit longer... he may realise that even though he thinks that the rest of the market is overvaluing the share, if $12 is the price that they are thinking is reasonable, they are almost certain to raise their estimates of the value after the lunchtime news. Certainly the chances of the price going up after the news is way higher than the chances that the price will go down despite the fact that Harry thinks it is generally overpriced; after all, the market has already shown that it considers $12 to be reasonable. Harry has a clear opportunity to make a profit by buying some shares before the news and selling them again when the price has gone up in the afternoon. For convenience, let’s label this idea the “early news trick”. From Harry’s point of view this makes perfect sense. Even though he thinks the rest of the market has overvalued the stock, it is still perfectly logical for him to buy the shares and sell them later in the day for a small profit.

Let us summarise what has just happened:

An intelligent person may decide to buy shares at a price which they themselves think is too high. This has not been caused by some temporary irrationality but by perfectly sound logic.

Notice that this trick is only an option in a system where there is no restriction on secondary trades. If there was a small tax penalty on secondary trades where the stock is owned for too short a period then this trick would not work. The tax penalty would destroy this profit-making opportunity. But also note that carrying out the trick would not have benefited Company X in any way, so the absence of the opportunity to perform this trick does not constitute a loss to Company X. The consequences of the trick would simply have been a transfer of wealth from a trader who got news late or was only able to respond to it slowly to a trader who got the news early and was able to respond to it quickly.

At this point some people may say that the early news trick is a fantasy, or very rare. It may constitute insider trading (which is illegal), or they may point out that government regulatory changes are kept perfectly secret until they are announced publicly to everyone at the same time. In response to this we would say that they were probably being naive, and besides, there is ample scope for employing the early news trick without insider trading or advance notice of government announcements. For example, you may hear some news being announced at the same time as everyone else but simply react quicker than the other traders. It may be that it is actually quite tricky to work out the consequences of the news report for the value of Company X. If you can work out the consequences in five seconds while it takes your rivals ten seconds to work it out, then you win: You can do the early news trick. This is precisely why you so often see panicked-looking traders shouting down telephones trying to buy or sell as fast as possible when important news breaks. Every second counts; even fractions of a second could be important.

Note: From this point on, when we use the word “news” it does not necessarily mean “world events” type news, it could just be some financial figures being made public.

Some may argue that even though the availability of the early news trick has no impact on the money that actually goes to Company X in the first place it is still of benefit to anyone whose pension or savings are being managed by Harry. It should be pointed out, however, that any money that Harry earns through the early news trick is always at the cost of another trader who is looking after someone else’s savings or pension. So there is no net benefit of Harry’s speedy response to the economy as a whole.

So far we have seen that the availability of the early news trick is perhaps of no benefit to the economy. Now let’s consider any potential harm the practice could do. In order to do this, let us go back to Harry and consider his thought processes again…

In the beginning of the story we told you that Harry had laboriously and painstakingly researched and calculated the true value of the Company X only to decide that it was a poor buy. But after getting that phone call from Bob and working out that he could do the early news trick, he should have realised that he need not have gone to all that trouble. The fact that he disagreed with the evaluation that the rest of the market had given Company X did not matter! This is a crucial realisation:

In order to profit from short-term share trades, you only need to consider likely changes to a share price from its current market valuation caused by immediate news and events. It is generally* of little consequence whether you happen to disagree with the current evaluation as determined by the rest of the market. *The word “generally” is here because under certain circumstances it can indeed become important but we shall get to that later.

Before we go on to discuss the consequences of this realisation we need to consider the existence of two phenomena: noise and market errors.

Noise and market errors

Noise

The word “noise” is used in a wide variety of mathematical and technical fields. It can be thought of as a kind of small jitter or disturbance. Shares that are subject to frequent buying and selling will be subject to noise in their price. Imagine for a second that there is no interesting news at the moment about Company Y. Imagine also that over the next hour 100 people will buy shares in Company Y and correspondingly 100 people will sell. When each individual share trade is made, it may affect the price a tiny amount. In keeping with the principle of supply and demand discussed earlier, a sale of a share acts as a signal that the price should come down a tiny amount, whereas the purchasing of a share acts as a signal that the price should go up. The person instigating the trade is the one who sends the signal. So now let us consider the 100 share trades that are due to happen in the next hour. Imagine that in 50 of the trades the seller announces his intention to sell and the buyer simply responds by purchasing, and in the other 50 the buyer announces his desire to buy and the seller simply responds to that offer. The net effect on the selling price after all the trades should be zero. But now let’s consider the order in which these sales take place. Assuming they occur randomly, it is most unlikely that the market will get signals in a neat order: buy... sell... buy... sell... It is much more likely that the signals will come in disorderly clumps, with two or three sell signals in succession followed by several buy signals. This means that the price of the shares will jitter up and down by small amounts purely at random. The jitters do not correspond to any news or analysis, but are simply random.

Market errors

People make mistakes. Even the smartest of people forget things, they can have gaps in their knowledge, they can make errors in their maths, they can get ideas conflated, they can be hungover from the night before… If they are in charge of purchasing large amounts of shares for a big bank they can make a mistake that will alter the share price slightly. If they buy shares due to a mistake then they will push the share price up. If they sell shares due to a mistake then they will push the price down. All for no fundamentally good reason. Let’s label this phenomenon a market error. These errors will no doubt happen on a daily basis. There will also be much smaller players in the market, with much less expertise, buying and selling smaller quantities of shares. The likelihood of them doing so for unsound reasons is far higher, though the effect their actions will have on the share price will be smaller. Those kinds of errors may happen many times per day, probably even many times per minute!

Noise and market errors will combine to make share prices jitter up and down for reasons that are nothing at all to do with the fundamentals of the true value of the shares. They are just a kind of “junk” signal that gets mixed in with the well-considered trades made by experts that are on top form and not hungover or otherwise below par. You may assume that this junk component of the signal is harmless, and the market will somehow cope with it in some rational way... but hold on. We have a problem. Most trades in the stock market are to own shares for short periods which means that the price of the shares is determined by the buying and selling activities of people employing the early news trick. These people have little incentive to accurately calculate the true value of shares based on fundamentals. Their modus operandi is to assume that the current price is somehow “correct” or “the well-considered valuation of the rest of the market” and all they need think about is the possible change to that price caused by the latest news.

Imagine that at some point the price of Company X rose by 0.5%. What should Harry think? Is it noise? Is it a market error? Is it the new, well-considered opinion by the rest of the market caused by some events that Harry is unaware of, or that Harry is aware of but is unaware has any impact on the value of Company X? He has no way of telling, and what’s more, the other market participants have no way of telling either! There is no obvious action Harry can take in response to this 0.5% change. He may as well take no action at all and simply keep tuned to the news and hope for another handy phone call from Bob.

In a market where most participants are employing the early news trick, there is no good mechanism for correcting noise and market errors.

The consequence of this is that at any one time the price will correspond to the sum of a series of small changes which are either noise, market errors or quick reactions to news events as they happen. This is a perfect recipe for the share price to drift away from its logical market value based purely on expected future dividends.

Considering the knowledge of other share dealers

Let’s re-join the story of Harry the day trader. It’s now the start of day two on the job. Harry is delighted with himself for having discovered the early news trick and has made a nice profit from having purchased shares in Company X before lunch and selling them in the afternoon. Suddenly the phone rings. It’s Bob again. This time the gossip from Bob is slightly different. Bob has just been tipped off by some pollsters that the election results in Maltovia are set to be a surprise victory for the left-wing party, overturning years of rule by the right wing. The result of the election is going to be announced at lunchtime.

Harry takes a moment to digest this information. He tries to work out if there is any impact of the election result on the future profitability of Company X. This time the connection is not nearly as obvious as the tax change. There are two factors to consider.

First of all the left-wing government is going to impose a 10% import tariff on foreign goods. This will clearly have a negative effect on the future profitability of Company X because it will sell fewer of it products to that country. Everyone knows this fact as it was trailed as the flagship policy of the left-wing party.

But Harry, who is a very smart guy, happens to also know some much less well publicised information: He knows that the left-wing government wants to impose strict new environmental controls on its mining companies which will dramatically push up the price of Maltovia’s main export: neutronium. Harry knows that neutronium is an important constituent of a product that is a rival to that produced by Company X. So a rise in costs for Company X’s rivals is clearly good news for Company X. Harry realises that, because the population of Maltovia is so small, the reduction in sales due to the import tariff will be more than compensated for by the much larger positive effect of the higher priced neutronium.

Harry calculates that the net effect of the two factors combined on the future dividend payments is a small increase of around perhaps 5%. Harry is correct in his calculations.

We now want to consider whether Harry can use this information to do the early news trick again. Now he has a real conundrum. The problem is that the connection between the election result and the change in the value of the company is much harder to deduce. Some people may not know that the rival product relies on neutronium, some people may not know that it is the intention of the new left-wing government to introduce the new environmental controls, but everyone knows about the import duty. Harry thinks to himself that if the market is dominated by people who only know about the import duty then the price of the shares will go down after the results are announced, but if most people also know about the environmental controls and the composition of the rival products then the price will go up. The likelihood of the early news trick working is now critically dependent on the knowledge and intelligence of the other market participants, and Harry knows it.

At this point let us consider the evolution of Harry’s job:

Harry started out on day one thinking that his job was to accurately estimate the value of shares based on expected future dividend payments.

But then came Bob’s first phone call which alerted Harry to the early news trick.

Harry could virtually ignore his own estimate of the value of shares and simply consider his estimate of changes to the value of shares based on news events.

But then came Bob’s second phone call which alerted Harry to the need to consider other people’s knowledge and intelligence.

Harry now realises that he has to estimate other people’s estimate of how the news will change share prices.

And now it gets worse still. Harry thinks some more and realises that the other market participants will all be playing the same game. There may be other people out there who are smart enough to know that the price should rise but are assuming that most other market participants are not so smart, so they may bet on a fall despite knowing that the effect of the news is positive for Company X. It’s rather like being at the cinema and noticing a very subtle gag, perhaps a certain facial expression, a raising of an eyebrow… You may chuckle to yourself, smugly thinking that you’re the only one in the cinema who got the joke... Little do you realise that the entire cinema is full of people smugly thinking they are the only ones who got the joke.

Harry now realises he has to estimate other people’s estimates of other people’s estimates of how the news will change share prices!

Harry has come a long way from his ideas at the start of day one.

No less a figure than John Maynard Keynes had deduced many of these features of stock market pricing back in 1936 in his book The General Theory of Employment Interest and Money. One feature in particular, the idea of investors predicting what other investors are thinking, has even been given the label: a Keynesian beauty contest.

So now we can see that the evolution of the share price of Company X is looking truly mangled. As the months and years go by, its price will end up as the sum of a collection of changes, each of which are based on noise and market errors that don’t efficiently get corrected, and a collection of short-term reactions to news by people who are aiming to predict how other people predict how other people will predict changes in the price. This process is a perfect recipe for compounding errors. It’s rather analogous to the following scenario:

Imagine there is a big jar of coins collected from around the world. No two coins are alike. You are set the task of answering the following question: If all the coins were to be balanced one on top of the other, how tall would the stack be? You have a choice of two methods to work this out. Method one is to simply make the stack and then measure it. Method two is to separately measure the thickness of each coin and then add up all the thicknesses. Hopefully it is obvious to you that method one is likely to be more accurate. What’s more it should also be obvious that the greater the number of coins, the larger the error of method two is likely to be. Given the fact that bulk of share trading is carried out over very short periods, the share prices are largely determined in a way analogous to method two.

At this point we could go on to describe Bob’s phone calls on days three, four and five which will give Harry even more ideas about how to profit from his day trading. With each phone call, Harry will realise more and more things that he needs to consider that have less and less relation to estimating the likely future dividend payments of Company X and more and more to do with the psychology and behaviour of other market participants. But we will spare you the gory details. You should be getting the idea by now:

Share prices can easily drift a long way from a value that corresponds to anyone’s estimate of future dividend payments.

Fisher Black, an economist made famous for his contribution to the “Black-Scholes equation”, once suggested that the market was doing well if the price of shares was within a factor of two (i.e. between double and half) of its true value. In a talk he gave in 1986 he said: “The factor of 2 is arbitrary, of course. Intuitively though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value.”

What is the benefit of unrestricted secondary share dealing?

So now we have seen that the effect of unrestricted secondary share dealing is wildly varying and “irrational” prices. This is clearly a big minus to any economy. The question we wish to address now is: Was it worth it? Is the upside of allowing unrestricted share dealing so large that it is worth enduring some crazy share price evaluations?

The argument goes that allowing an unrestricted secondary shares market means that a company can sell at a higher price at its IPO. Any restrictions on secondary dealing would deter potential purchasers because they may want the flexibility to sell their shares again at any time. This may indeed be true but it is important to consider how much of a reduction in the selling price would be caused by various restrictions on secondary trades. Obviously it will depend on exactly what type of restrictions are imposed. Let’s try a thought experiment to investigate this issue...

Imagine a company director, let’s call him Fred. He wants to sell all or part of his company for some reason; perhaps he needs the money for new machinery or he wants to sell up in order to start a new business altogether. He declares to the market that he is going to issue shares for sale for the first time. He hires a big hall and invites a large collection of potential purchasers (this isn’t how it’s done in practice, of course, this is just a thought experiment). He gets up on a stage at the front of the hall and makes an announcement: “My company is well run and profitable. Please buy my shares and you shall receive high dividend payments for years to come.” The people have been given prospectuses with all the business plans, forecasts, the latest accounts etc. They have had ample opportunity to determine just how good a purchase the shares will be.

Now imagine each person in the room has been given a special device with a keypad and they are instructed to secretly type in the highest price they would be willing to pay for the shares and how many shares they would buy at that price. A computer connected to all these devices would then work out the optimal selling price such that the company earned the greatest amount of money from the sale. The people in the room busily type in their numbers. The computer does its calculations and declares that Fred should offer his shares at exactly $100 each. The computer has worked out that $100 is the highest price he could charge such that all the shares get sold. Any more and some would go unsold; any less and there would be disappointed customers that would be unable to purchase. The price of $100 will exactly balance supply and demand for the shares.

Fred is just about to instigate the procedure to actually make the sale, but before he has time to press the metaphorical “sell now” button, he gets interrupted... It just so happens that there is a radio on in the corner of the hall, and just at that moment a newsreader says, “The Ministry of Finance has just made a surprise new law about share dealing. Anyone who buys shares, either an initial share issue or a secondary trade, is to be discouraged from re-selling them within a period of less than one month. Anyone re-selling within a shorter period will have to pay a penalty tax of 2%.”

The people in the hall take a few minutes to digest this news and consider its impact. They demand that Fred cancel the current bids and redo the auction. Fred makes an announcement: “Please now adjust the figures you previously typed into your devices, taking into account the news we have just heard.”

The question is, what will this new, post-announcement price be? Will it still be $100? Will it drop to $98? $90? $0? In order to answer this question we need to consider the plans and motivations of the people in the room. If someone fully intended to invest in the company for many years to come, then pretty much any type of restriction on reselling the shares is going to be of very little or no consequence. If it was someone’s firm intention from the outset to only hold on to the shares for ten minutes, then their plans will be ruined by the announcement. They may conceivably drop their bid to zero. But now we need to ask – why would someone want to buy shares and then sell them ten minutes later?

The only conceivable reason someone would want, from the outset, to own shares for some very short period is if they personally knew in advance of some information that would only become apparent to the rest of the market during that short period. If that information was already known to the market before the sale then that information would already be factored in to the price and no conceivable advantage could be gained. Similarly if that information was to become available only after the short period, then again no advantage can be gained. The shorter the period in question, the less likely it is that any of the bidders knows a) such a piece of information and b) that the information is likely to become apparent to the rest of the market during that short period.

Some people may say, “Okay, but what if someone has no particular plan (at the outset) to sell after only a short period, but they would like the flexibility to freely sell at any time because they may suddenly and unexpectedly need to use their savings?” Indeed there may be many people in that position. You may then assume that these people would then lower their bid in order to compensate for the possibility that they may have to pay the penalty tax. Note that this is a possibility rather than a certainty, and this is crucial. If someone thought that the probability of having to sell their shares within one month was 10%, then the amount by which they would drop their offer would not be the full value of the penalty tax, but something in the order of 10% of that amount, i.e. 0.2%.

Some people may say, “Okay, but what if someone has no particular plan (at the outset) to sell after only a short period but they would like the flexibility to freely sell at any time so that they can quickly sell if the share price falls?” This is a more complicated issue. We now need to consider things like the potential share purchaser’s perception of the probability of a sudden fall, along with an estimate of the size of any falls and also the probability that the purchaser can anticipate the fall. After all, if there is a sudden fall and you are too slow to react and are still owning the shares after the fall has occurred then there is little point selling now. The damage has already been done. The new lower price should now, in theory, be set so that it once again corresponds to the current value of predicted future earnings. So if you don’t think you can anticipate a sudden fall then you have no reason at all to lower your original bid. Even if you do think you can anticipate a fall then the most you could lose through having to sell in a hurry is the 2% penalty.

Taking all these factors into consideration, the drop in the price that Fred would suffer due to the 2% penalty is likely to be less than 2%, because some fraction of the people will no doubt perceive that the probability that they will be forced to sell during the one month period is low or even zero.

We could have described the share sale thought experiment with a variety of different announcements being broadcast on the radio about different types of restrictions on secondary share trades, different sized penalties, different minimum ownership periods or entirely different types of restrictions, and in each case there would be different corresponding reductions in the post-announcement price compared to the original.

In Table 14-9 we have drawn up some, admittedly unscientific, estimates of the relationships between different announcements and the size of the effect on the original selling price. We do not claim that these figures are necessarily accurate or that they are based on any empirical evidence. We merely suggest that a) they are a reasonable guess and b) it is reasonable to assume that small restrictions on secondary share trading would have only a very minor effect on the amount of true investment (i.e. the money that goes to the original company) that is achieved through the entirety of the share purchasing and trading system.

Restriction on secondary share trades	Guesstimated fraction of unrestricted initial selling price
5% tax on all secondary share trades if selling within one year of purchase	96%
4% tax on all secondary share trades if selling within one month of purchase	97%
3% tax on all secondary share trades if selling within one week of purchase	99%
2% tax on all secondary share trades if selling within one hour of purchase	99.9%

In conclusion it appears likely that the cost to companies at IPO of a system in which there was a small penalty tax if shares are held for too short a period, is quite minimal while the advantages of having such a system in terms of price stability (and sanity) could be enormous. An additional benefit would be that all the, often highly skilled, day traders and high frequency traders that perform little useful purpose for an economy would be forced to do something useful instead.

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