FOOL ON THE HILL: An Investment Opinion
How Money Is Made in the Market

At every turn, someone else seems to be commenting about how they've made money in the stock market. But what does that statement really mean? The answer has little to do with direct investments in a company or handicapping a horse race. Instead, the fundamental factors for wealth creation in the stock market are still earnings and the multiple placed on those earnings

By Brian Graney (TMF Panic)
September 12, 2000

Of all of the catch phrases in modern American society, one of the most popular over the past few years has to be "I've made money in the stock market." While this expression has been batted around quite a bit in normal discussions and in all of those stereotypical cocktail parties, not much time (or columnist ink) has been spent on considering what this statement actually means.

Making money in the market is not like making money at work, where the normal, everyday worker shows up at the office and effectively gets a cut of the company's economic performance in the form of a paycheck every two weeks or so. I know, I know, this view is simplistic -- many Internet companies don't actually have economic performance, and so on. Still, this is the basic way that business paychecks are created. In contrast, how are stock market paychecks created?

The wise-aleck response to this question is "by buying stocks that go up." While replete in truth, such a response is devoid of thought. Just where does the money from big investing "wins" come from? The correct explanation is that it comes from a couple of sources, although sometimes investors can get hung up on misperceptions that lead them toward incorrect conclusions about what is really going on in the stock market.

A basic misperception
One of the big beginning investor misperceptions that I see on a regular basis derives from the investor who believes that by calling Charles Schwab and placing an order for $100 in shares of Peter's Pipedreams Inc. (Ticker: HOPE), his or her $100 is actually going to be used by the company in some way. As the company grows, so too does the money invested in it, providing our happy investor with a nice return.

Unless we're talking about initial public offering shares, the reality is that Peter's Pipedreams will never see that money. Instead, a brokered transaction takes place on the secondary market between a buyer and a seller, neither of whom usually have any connection whatsoever with Peter's Pipedreams outside of a stock certificate. So, different interpretations of the word "investing" itself can lead to problems about the root cause of wealth creation right off the bat.

The zero-sum fallacy
Additionally, given the one-buyer, one-seller nature of a typical brokered transaction, there can be a tendency to assume that stock trading and the market on the whole is nothing more than a zero-sum game. In other words, in every trade one person wins while the other hapless soul loses. The person that ends up on the winning side of the trade more often than the losing side ends up making money in the market. This is another investor misperception.

In game theory, zero-sum describes a game where one player's gain is another player's loss and the total amount of the available desired element (money, poker chips, chess board squares, Hungry-Hungry Hippo balls, or whatever) is fixed. In an isolated example like our earlier Peter's Pipedreams trade, the result could over time appear to be zero-sum. If Peter's Pipedreams goes on to set the business world on fire and its stock price appreciates, the buyer certainly appears to be the winner with a capital gain at the expense of the seller, who incurs a loss in the form of a lost opportunity to make big money.

This thought process would work great if the stock market consisted of only fixed elements rather than a hodge-podge of variables, but it does not. In fact, hardly anything in the stock market as a whole is fixed. The size of the pot (or the market's total capitalization) can get bigger or smaller, depending on the number of investors involved and their changing willingness to commit funds to the market at any point in time.

Likewise, the number of companies in the market can increase or decrease as new companies come public or as existing companies go bust. Even Peter's Pipedreams itself can change the parameters of the game on a micro level by selling more shares or by buying in shares that it has previously issued. Both actions effectively change the availability of the desired element (its shares).

Investing is not horse racing
The existence of changing parameters drives a wedge in the argument that the stock market is nothing more than a giant pari-mutuel betting system, akin to the system that exists in horse racing. To be sure, there are some definite similarities between the track and the stock market. Perhaps the most obvious is the allure of the longshot in both, with the eternal search for the next Microsoft (Nasdaq: MSFT) having much in common from a psychological standpoint with the desire of finding that winning pony with the 100-1 odds.

But the commonality of "swinging for the fences" strategies aside, the fact of the matter is that horse racing is a zero-sum game, with no real wealth created as each winner is simply paid out of the fixed pool of money that has been bet on each race. The stock market is a bit more complex than that, with wealth created not just by the supply and demand tug-of-war of the market itself but by the underlying value creation ability of the individual companies that make up the market.

The importance of earnings and multiples
In short, to understand how money is made in the stock market, investors should clearly understand what makes stocks go up. As it has been said in this space before, the hard and fast truth is that only two factors determine stock prices over time -- the level of corporate earnings and the multiple that investors are willing to pay for those earnings. By accepting stock prices for what they actually are, an investor is able to take the correct path of viewing a stock as a marketable interest in a business, rather than as a direct investment in a company or a horse in a race.

If a company can take market share, expand margins, raise prices, cut costs, or in some other way boost its profitability profile, its earnings will expand. Likewise, a company's multiple is determined largely by the strength of its earnings today and the outlook that it can continue to produce strong earnings tomorrow, as well as market-related factors including the desirability of equity securities relative to other asset classes. This is the business value creation story, and investing in this is how money is made in the stock market. Anybody who says otherwise is just making cocktail party small talk.

Related Link:

  • Why Do Stocks Go Up?, 1/7/97 (Scroll past Heroes and Goats)