Friday, October 10, 2008

So, just what is the stock market?

Let's Have a Business!

Today I had someone I know asked the question "What's the actual value of having a stock market exchange? Seems like the stock market allows for people's skittishness to have real effect."

I'm no economics expert, but I at least recall some of my college classes and how I've explained it to other people over the years.

First, let's look at how a normal business is run - or how it was run, before the stock market existed.

So, let's meet Bob:

Bob wants to own a business - let's make one for him.

Bob Widget Company makes - widgets. What's a widget? I don't know - it's something that people want to buy. Usually.

Now, suppose that Bob invest $1000 into his company. He buys a store, he pays for a Widget Expert to train employees. He buys special Widget Making tools. He owns 100% of that company. Every profit it makes is all his. Every time he sells a widget, he takes the money and puts it right into his pocket (well, after paying his expenses.) It's Bob's money! All his! Bwahahahahahaha! If the company grows and becomes worth $10,000, Bob would sell the whole thing and make a nice profit.

But - what if something bad happens. Like, people decide that they won't want widgets any more. Now, all of Bob's investments - buying the shop, the tools to make the widgets, paying to have employees trained in the Ancient Art of Widget Making - gone.

All of that $1000 Bob put into the business is gone. He could take 100% of the profit - but he also assumed 100% of the risk. All of that money is gone.

Now, let's see about a partnership. Meet Bob's friend Frank. No, they're not brothers. They just look a lot alike.

Now, both Bob and Frank start the business together. Since it's still going to be Bob's Widget Company, let's have Bob own most of the company - say 60%. Frank will own the other 40%. They draw up a private contract, maybe get a lawyer to stipulate how things are to be split up.

Same company:

But now it's shared between the two co-owners.

Bob puts in $600, Frank puts in $400, and they run the company together. The good news is if something goes horribly wrong, Bob's only out $600 instead of $1000. Yay for him!

The downside is now, he has to share the profits with Frank - 40% of them. And he has to share some of the responsibilities with him. Maybe not - perhaps Frank isn't the pushy kind who's always asking to get his say in everything.

And even if Frank is - hey, Bob still owns 60% of the company - he has more power than Frank. Still, it can be tense if things aren't laid out between who does what.

Bob could reduce his risk more if he wanted to bring in more partners. On the one hand, the more partners Bob has, the less risk he assumes - but the more control of power he has to give up.

Of course, there is another way.

Let's have a market!

The good part about having more partners is that the risk is divided. The bad part is having to share the power, the profits, and most importantly, the ownership.

What if Bob teams up with a group of people - Frank, Nancy, Jo Bob, Latesha, and Fredo.

Everything's fine - each of them put in $200, and split the profits between them. Maybe they share some responsibilities, but overall things are going well.

Until Frank decides he has to leave town. No, don't ask why! It has nothing to do with the three state killing spree! But he wants his money. And since there was a private contract that detailed what Frank's powers and responsibilities were in exchange for his $200 ownership into the company, there's that whole headache to deal with. Who takes over Frank's responsibilities? Do the other partners buy him out? What if the value of the company has gone up, and now Frank's $200 is really worth $1000 - how does that get solved?

Another solution: stocks.

Instead of setting up partners and making individual contracts with everyone, you start with a Charter - a piece of paper that says what the company does, lays out the roles. You don't assign *people* to those roles usually - but just what the roles *do*.

Usually, you'll have a breakdown of roles like:

CEO: Chief Executive Officer - this is the person running the company, making the big decisions.

CFO: Chief Financial Officer - this person is in charge of how money will be gathered and stored and such.

CTO: Chief Technology Officer - the Geek God of the company.

And so on and so forth. There are probably rules about who can own the company - an initial group, then if they want to add new "shareholders" the group can vote on who they'll allow to sell shares to.

Remember how everyone put in $200 into Bob's Widget Company, and there were contracts that everyone signed about what they did? Well, instead of just everyone putting $200 into the pot, the company is split up into "shares".

Originally, Bob's company needed $1000 to get off the ground. If we split the company into 1,000 pieces, then you have 1,000 "shares" of the company, and everyone in the group can buy them up. Bob, being the guy who got this off the ground, buys up 350 shares. He owns about 35% of the company. Maybe Frank buys up 200 shares, and so on. Everyone owns a stake of the company, and however many shares determines how much of the company they own.

The importance here is now each member knows how much power they own based on how many shares of stock they own. Bob may own the biggest chunk of the company, but if everyone else teams up against him, they could overrule him. Unless Bob offers to buy up the shares of someone else's stock in the company, or can convince a majority of shareholders to go with him.

When Frank wants to leave, the other members just buy up his shares of the company, and they can vote a new person into Frank's job. Maybe the new person will buy some shares of the company, or maybe he'll just be another employee.

Now you can have movement in and out of the company. You don't have to do complicated contracts in and out. You know how much of the company is owned by whom at any time because they'll wave their pieces together.

And - the values of those shares can rise and fall. If the company does well, perhaps there an explosion of widget buying out there, the company grows. So those shares that were originally worth $1 each might be worth $10 each when the company is worth $10,000.

Of course, if the company shrinks - maybe there's an economic downturn, the shares of stock may be worth less. Value goes up or down as the company grows or shrinks.

So why do this? Well, by unleashing the forces of "the market", people can quickly raise investments. Bob's company can issue new shares of stock into the world, and raise money when needed. Of course, this means they're giving up some of their ownership, but that may be OK. It allows investors to decide how well Bob's company is doing, and add value to it by buying stock. People can swiftly move in and out of the business - which can be pretty good for business in general. If Bob does well, his company's value will grow. If he doesn't, well, investors can go buy someone else's stock in another company.

The big advantage to the entire economic situation is speed, and the ability to raise money for your company. Instead of complicated legal agreements with everyone who wants to be a partner in the company, now that ownership can be traded, bought, sold, and even allows new leadership to arise.

So - What rules should be followed for a good market?

The original question was - why have a stock market at all? Our little system seems to work all right. People can trade in and out. Maybe Bob sells all of his shares and goes to do something else.

But what when things go wrong? You've got 1,000 shares of stock running around, but how do you really know who owns what? What if one of the partners forges shares of stock? Or if there's some financial wrongdoing that leaves the company in ruins - not because the company was bad, but because someone did something that purposely devalued everybody else's shares, just so they could buy them up later?

Introduce - the stock market. The shares of thousands of companies, billions of shares are traded back and forth. Whoever wants to buy them can if they have the money, or can sell them when they can find someone who buys them.

At the same time, there's a system in place in the form of the SEC - the Security and Exchanges Commission. Every company that sells stock tells the SEC how many shares of stock they have out there, and who owns them. If companies want to merge, the SEC gets to decide whether there will be a problem (like if the merger will create a company that could be a monopoly).

This relies on there being transparency about who owns what shares of what companies. On the down side, this does mean that people's emotions can influence how much a company is worth, instead of just how well the company is doing. If there's a disaster, prepare for massive sales of company stock - which could hurt the company if they want to sell stock later to raise money. Or, as in the tech bubble, stock can be artificially high - until people realize that the shares they hold aren't worth the paper they're printed on.

So why have it? Because, overall, it does work. When there's proper regulation and oversight, the stock market has proven to be a powerful way to create new investments and grow the economy and jobs.

Of course, when there's not, then you can have a disaster - like we have right now. A lot of the ills of the stock market can be laid at investments that had no government oversight at all - private contracts between companies buying and selling shares of things that the government never knew existed. For more information, I really recommend you listen to NPR's show Our Confusing Economy, Explained and Another Frightening Show About the Economy - both shows feature Mr. Greenburger, a former commodities regulator, explaining default credit swaps (the private contracts the government didn't regulate that are bringing people down).

When markets are well regulated, it can work like a good sports game. Think of a Nascar race. There's rules about what kind of engines can be used. Rules about how fast the cars can go, what kind of tires can be used. There are fences around the tracks. When there's an accident, there are pace cars that force a slow down.

For the last 8 years, people in the markets said "Look - let's not worry about the rules. I mean - if it gets too fast and dangerous, people will slow down on their own! And let's take down the fences separating the fans. They don't need that - they want to be right in the action! No more pace cars - if there's an accident, the people will clear themselves out - we want the race to be exciting!

Only - now we know what happens when you don't have any controls over the market or a race. The cars all go as fast as they can because it's all about Winning at all costs. Now there's a massive pile up, several drivers are dead, some have crashed into the crowds and set people on fire -

And the people running the races are going "Duh - gee, I guess the drivers won't regulate themselves."

I'm sure there are even better explanations out there, and if you have them, pass them along. For now, this is my little explanation on how the stock markets work. Hope you enjoyed it.

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