The Stock Market is a Ponzi Scheme. Fully explained.
When we think about the stock market, we think about money, the finance industry, businesses, and making money from investing in successful businesses. The belief is investing in successful businesses is what leads to investment profits, and there's a direct connection between the success of the underlying company and the profits investors experience. This is a reasonable idea, which is why it's in textbooks and recited by finance professionals who sell stocks and stock-related services.
However, this is not how stocks actually work. Most finance professionals have no idea where profits from stocks come from; they just assume it gets magically generated from the complexities of the market. The myth is profits from stocks are generated from the earnings and growth of the underlying companies, and when a company makes money, they share the profits with their investors. But in practice, most public companies never pay dividends on their stocks, and when they make money— which can be millions or even billions— they keep everything.
The reality is profits from stocks come from other investors who are buying and selling stocks. When an investor buys a stock for ten dollars and sells it for $11, then $11 comes from another investor, someone who will then start hunting for yet another investor who will give him 12 dollars, and so on. This is technically a negative sum scenario for investors because they are contributing all the money, and there are fees attached to every transaction. The company that issued the stock isn't involved in these transactions, so whether the business is making or losing money is irrelevant.
This is why companies like Tesla Motors, who have lost billions since they became a public company, can still have stocks that appreciate in value. But in a situation where investors' profits are strictly dependent on money from other investors, investors can make or lose money regardless of whether the company they invested in is making or losing money.
In reality, the stock market is a massive system that shuffles money between investors. It is a system where current investors' profits are directly dependent on the inflow of money from new investors. Such a system is also known as a Ponzi scheme. But what most people don't realize is that a Ponzi scheme can also produce a lot of winners. It's not a scam where everyone loses money. Even with the presence of middlemen and fees, a lot of investors who are involved and unaware of the scam can make money.
The fraudulent aspect of a Ponzi scheme is not its inability to produce a few winners; the issue is in the mechanics and where that money comes from and how investors who make money are taking it from other investors who also want to make money. But if the stock market is a giant Ponzi scheme and it's as obvious as tracing the cash flow of a typical stock transaction, then why is it legal? If stocks are Ponzi assets, why are finance professionals allowed to sell them to investors, and why are there so many university classes and textbooks on stock analysis, but not one of them mentions the existence of this Ponzi factor?
Finance professionals do not see the stock market as a Ponzi scheme because they believe in several fallacies. These are ideas that people assume are true because they heard it from someone else, but the credibility for these ideas comes from repetition, tradition, and people who recite it rather than proof, logic, or facts.
The first fallacy, and the most fundamental falsehood that leads to other false ideas, is the notion that stocks are equity instruments that represent ownership in a company and that the value of the stock is connected to the value of the company. This idea is false because the values of stocks have no legitimacy. A real estate transaction has legitimacy because the value of the property is backed by the intrinsic physical value of the property itself. The value of a bond is also legitimate because there is a defined entity that is responsible for repaying the face value. But stocks have no legitimacy because no one has any obligations to repay the shareholders anything.
A share of Google might trade for $900, but Google explicitly states in writing that the share has no voting rights. They don't share business profits with their investors, and Google is only obligated to pay the shareholder the par value of 0.001 cent for that $900 share. Finance professionals confuse stocks with ownership instruments because they ignore history. Before the 1900s, stocks paid dividends, so at one point, stocks were legitimate ownership instruments because there was a profit-sharing agreement between the shareholders and the company they owned. That's how stocks used to work, and that is how stocks are supposed to earn, but that is not how stocks work now.
The second fallacy, which is a product of the first fallacy, is the idea that the asset value of a stock is the same thing as cash. When people see a share of Google that is trading at $900, they will just assume that is $900 in real money. But the value of a stock is just an idea. It is just a thought, something completely imaginary, which is why the price can rise and fall sharply at any given moment. On the other hand, money is an instrument for trade that is designed to serve as a medium of exchange for goods and services. It is in both physical and electronic form, and for the most part, it is finite and traceable.
It is legal tender that is issued and backed by the government, and it is what investors ultimately care about. Investors do not buy stocks for the sake of having stocks; they buy stocks because they want more money. As of September 2017, the New York Stock Exchange and Nasdaq had a combined value of over 30 trillion dollars. However, there is only 1.6 trillion dollars of real money in circulation in the entire US economy. The investors who are holding 30 trillion dollars in stocks will never receive the 30 trillion dollars in real money they feel entitled to because that amount of money simply does not exist.
The third fallacy is the assumption that the stock market is positive-sum for investors and that the system produces more wins than losses. This is why finance firms can label their products and services as investing rather than gambling, and why eighteen-year-old kids can open online trading accounts. However, the positive-sum assumption has never been proven. To show if the stock market is positive-sum, all we have to do is add up all the money investors have won and lost over the years and see if that adds up to something positive. The problem is no one knows how much money people have lost. There is no database that tracks investor losses, and no one knows how much investors have been winning or losing over the years.
The reason why people think the stock market is positive-sum is that they believe in the second fallacy and think people must have made money because the stock market has grown to 30 trillion dollars. But a real positive-sum situation needs to consider the wins and losses of all the investors that are involved, which includes the last investors building 30 trillion dollars of imaginary money that doesn't exist.
The idea that the stock market is a giant Ponzi scheme isn't new. As repulsive as this idea is to finance professionals, it's not an idea that they can properly deny or refute. They cannot explain how investors can make money without taking it from other investors or shed any light on how much money the investment finance industry has lost for investors over the years.
The typical way finance professionals defend the Ponzi factor accusation is by bringing up hypothetical scenarios, such as what a company can or might do in the future. They'll say things like Google can start paying dividends or Tesla might start making money. Hypothetically speaking, anything could happen; the world of the hypothetical is only limited by our imagination. The problem is those events are unforeseeable and don't happen in practice. But on the other hand, the Ponzi scenario— where investors are feeding off each other while the companies they own hoard profits— this is not a hypothetical situation. It is what is happening in practice. This is a very real scenario, something we can observe every single day.