Tuesday, March 10, 2015

Is the Stock Market Rigged?

I recently had dinner with a friend who abruptly asked “is the stock market rigged?” As I attempted to fully understand his question and address his concern, he ultimately said “if someone makes money by conducting a trade he wins, and if someone wins, doesn’t someone have to lose?” This viewpoint was preventing my friend from investing in his employer’s 401k plan or an individual retirement account.

While I can see the logic in my friend’s viewpoint, I don’t think it is accurate. Many people are reluctant to invest because they don’t want to be on the losing side of an investment, opposite a more experienced and skilled investor. This hesitancy likely stems from the fact that investing in the market requires the purchase of an intangible asset. However, I believe the same reasons that make purchasing a more tangible asset like a home worthwhile also apply to investing in the market.

When an individual purchases a home, he does so for a reason – he needs a place to live. For most people, the need to put a roof over his head is more of a driving force to buy the home than because he believes the current price is lower than the home’s actual value. The person only sells when his needs are no longer matched by the home – perhaps because the individual has retired and wants to move to a warmer climate or have a yard that doesn’t require much maintenance. When he sells, assuming enough time has passed since the house was purchased, the individual hopes to sell the home for more than he paid for it.

Assuming the individual does sell the house for more than he paid for it, does that make him the winner and the new purchaser of the home a loser? Of course not. The new purchaser is buying the home to fill a need, just as the original purchaser did. Similarly, assuming the new purchaser owns the home for a long enough period, chances are pretty good that he too, one day, will sell the home for a profit.

When we examine the purpose of investing in the market, it is very similar to why we purchase a home. First, we invest in the market because we have a need – to not outlive our assets. Again, for most people, the need to save for retirement is the primary reason we invest, not because we believe the market is particularly undervalued. Similarly, we only sell our investment when it no longer matches our needs – perhaps because we need to convert the asset to a more liquid and tangible asset (cash to buy a car), or because the investment has become more risky than we are willing to tolerate later in life. Just as the home provides a benefit (a place to live) while it is owned and is later sold at a higher price after enough time elapses, our investment in the market provides a benefit (dividends) while it is owned and is later likely sold for a higher price after the passage of time.

Again, just because the selling market investor sold the asset for more than he paid for it doesn’t make the purchasing investor a loser. The purchasing investor will benefit from the same dividends the first investor collected, and if he holds the investment long enough, will also likely sell at a profit when the investment no longer meets his needs. When the market continues to increase in value after the first investor sells, it doesn’t make the seller a loser. He is still a winner in that he made a profit from investing in the market and was later able to exchange the intangible investment for a more tangible asset like a new car, an exotic vacation, or simply the ability to not outlive his money.

There is, however, a factor that can potentially cause a winner/loser scenario with both the purchase of a home and an investment in the market – time. After buying a home, we are much less certain that the home’s value will have increased after only a month as compared to ten years. The impact of time is the same when investing in the stock market. We can be far from certain that the market will increase in value after only a day, month, or even a year. However, you’d be hard pressed to find a ten-year period when a diversified investment portfolio didn’t increase in value to some degree. Consequently, while both buying a home or investing in the stock market to make a quick profit is far from certain, history tells us that doing either to fill a need and with a long-term investment horizon is likely to yield a win-win situation.

1 comment:

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