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Explain to me why trading stocks is a good thing
January 25, 2014 10:26 AM   Subscribe

After reading stories like this, I've been wondering about the financial industry's larger role in the world. Other than the people that run the system, who benefits from the financial industry and how?

It's obvious to see that the people running the system come away with tons of money (as in the above editorial). My question then is, who benefits from the toils of the lowly hedge fund manager, other than the manager themselves?

To put this in more concrete terms, think about high frequency trading. Programmers make minor modifications to algorithms in order to eek out tiny speed boosts for the automated trading systems.
Is there any benefit, other than increased profit, that follows from this endeavor? Do home prices stay more consistent? Do products become cheaper for consumers? Does anyone's life get better?

In fewer words: Is the financial system just a whole bunch of people making money to make money?

*I realize financial system is an overly broad term, but I am not conversant enough in finance to understand it's categories and subcategories.
posted by lalunamel to Work & Money (13 answers total) 10 users marked this as a favorite
Most financial system boosters will tell you that stuff like high frequency trading provide the market with more liquidity, which means that when you re-jigger your 401k, there's an entity out there that will either buy what you want to sell, and sell what you want to buy.

As for the rest of the system, it's not a terrible way to allocate capital and price risk, in theory. Like all human institutions the system falls short of its potential (depending on your expectations for it -- efficiency, equality, transparency) mostly from being all too human.
posted by notyou at 10:37 AM on January 25 [2 favorites]

As notyou says, it may seem to us like there is just some infinite pool of "stocks" to which one buys and sells, but in reality, every time you buy a stock, there needs to be a seller, and every time you sell a stock, there needs to be a buyer on the other side. Increased liquidity means that one is better able to buy and sell stocks at accurate prices.

The ability to repackage loans and mortgages as bonds and buy and sell them on the open market at accurate prices means that it is easier to lend and borrow money. The ability to buy an sell your own business and get a fair price for it is helped by our ability to have liquid markets that provide the capital and loans for these transactions.

That's the ideal, of course. The reality is that we just let these things go on in a basically unregulated fashion and that, as one of the financiers quoted in the article says, they don't have any time or inclination to think about the "big picture", just about how much money they make. As we hit the limits of high frequency trading, there have been proposals to discretize market prices-- any change in price will occur at fixed time intervals to give the price time to electronically propagate to the rest of the world because it can begin trading at that price, rather than dealing with the arms race of moving trading servers closer and closer to major network hubs beneath trading floors.
posted by deanc at 10:58 AM on January 25 [2 favorites]

Is there any benefit, other than increased profit, that follows from this endeavor?

No, but why should there be? Money is the product in this industry. So, yes, it's all about money, but what else would the financial services industry be shooting for? You go to money experts with your money to make money. It's no different from the pet boarding or guitar making industries, but here it's money. It's proper and necessary. You don't expect any other industry to concentrate on anything but its product, at least not in a capitalist economy. Everyone narrowly pursuing their narrow thing aggregates into a thriving whole. That's what an economy is.

It's the job of the government to set (and enforce) ground rules, so the country doesn't get chewed up by the machinations of this particularly clever and brutal industry. The problem is when the machinators get so powerful that they set their own ground rules and/or easily dodge enforcement. But that's the result of political corruption, not industry malfeasance. It's natural for the players to try to relax the rules; that's part of the game. But just leaders resist. And an aware, educated populace punishes them when they don't. Problem is modern psychology/marketing tools make it easier to control the thinking of the populace. The equilibrium has been jacked.
posted by Quisp Lover at 11:01 AM on January 25 [2 favorites]

Most of the people who live and breathe this stuff and don't directly get bonuses from the trading houses that do it (including Warren Buffet-the most successful trader there is) agree that high frequency trading not only doesn't provide anything useful to society it actually hurts the market and the ability to find accurate prices for stocks and commodities.

As for traditional market trading it really does help allocate capital and resources effectively-at least as far as getting the most from limited resources i.e. money and resources flow most toward those entities (companies/corporations) that can do the most with them. However to do this, real human beings need time to analyze just how the companies are allocated those limited resources and how they are using them to increase value (note this is not just in terms of money but rather in terms of value-increasing wealth over time which includes more than just dollars in a bank account). When this kind of trading takes place stuff does actually get better as the people who have figured out better ways to do things get the rewards and new people who figure out even better ways to do things get rewards and the system builds on it itself (once again-ideal world stuff but in a lot of cases it is what has happened over the course of history).

The above is an ideal theoretical model but it is the one put utilized by Warren Buffet who is the worlds richest man (or at least the top 5 depending on the year).
posted by bartonlong at 11:04 AM on January 25

The general question you're asking is pretty darned big because "financial industry" covers a lot of ground. It's like asking, "is capitalism good for regular people." Like, what do you mean? Does having a grocery store in my neighborhood benefit anyone besides the grocer? I would say yes, but I imagine someone with a very different philosophy than me could conceivably answer 'no'.

There are specific slices of the industry that have been covered in MeFi before, like HFT, and people have differing opinions about it. But this is like, many many levels down.

Think about stocks, as a very basic example. Listing a company on an exchange (going IPO) benefits the company because they get to raise a lot of capital so they can do things they couldn't do before without that money. In exchange they give away fractional ownership of the company. This benefits the public because you get to have partial ownership in a company, and the associated profits (if there are any) without actually starting a company of your own.

So what's the alternative? Like, if we didn't have a stock market? As a business owner, you could still sell part of your company to an interested individual(s), just like non publicly traded companies do today. As an individual, you have to find an owner willing to sell part of his company to you, and you have to have enough money to buy. Basically, the buying and selling of fractions of a company, a.k.a the "stock market" exists as a way to make something that people want to do, easier and more efficient.

Now expand that out several hundred times, and you get the financial industry of today, with the multitude of instruments, some exotic, and in addition to individual buyers and sellers you also have institutions representing the interests of many buyers and sellers (like pension funds, etc.). Everything as it exists today is the result of an evolutionary pressure to be more efficient, a.k.a. make more money.

This is why regulation and reform is hard to talk about. Because the industry itself is layers and layers, and is hard to talk about.

To answer you question directly, yes and no. The financial industry exists to enable people and companies to do what they want, which are real and tangible things, but this is kind of philosophically inextricable from the idea of profit, at least under the capitalistic society we currently live in.
posted by danny the boy at 11:09 AM on January 25 [2 favorites]

The primary, and original role of the financial industry is to provide businesses and individuals with financing. In other words, to help people raise money, and to connect those with excess capital (bank depositors, investors) with those in need of capital (businesses wanting to raise money, individuals taking out a mortgage).

If a business needs to raise money, it can:
1) Borrow money by issuing bonds. Pay interest and eventually pay back the debt.
2) Sell a stake of itself by issuing stock. This raises money without going into debt, but those who buy the stock now collectively own the business. The company might decide to compensate shareholders by paying out profits in the form of dividends, or they may choose to re-invest this money in the company.

The bond market, stock market, derivatives, hedge funds, high frequency trading, etc. can be thought of as secondary results of the above. People buy securities (bonds and stock) as a form of investment. They trade them with each other because of differing investment time horizons, differing liquidity needs, and differing opinions about the market and the companies/governments issuing those securities.

My question then is, who benefits from the toils of the lowly hedge fund manager, other than the manager themselves?

The investors of the hedge fund. Hedge funds manage money on behalf of investors, who typically pay them a flat fee of ~2% a year for their services. If they make a profit, the hedge fund keeps 15-20% of the profit. Why do investors give money to hedge funds instead of investing it themselves, or putting it into an index-tracking ETF or mutual fund? Because they think the hedge fund can do a better job over time. Whether that is true after fees is debatable. Nobody is forced to invest in a hedge fund.

Is there any benefit, other than increased profit, that follows from this endeavor? Do home prices stay more consistent? Do products become cheaper for consumers? Does anyone's life get better?

I wrote a number of comments on this in the last HFT thread on the blue. Here are my comments [1] [2] [3] [4]. Essentially, HFT provides more liquidity to the market, which can be thought of as a small collective benefit for all market participants - e.g. investors are able to pay a few cents less in transaction costs every time they buy/sell a stock, which over many transactions by many people adds up to money saved. They make the market more efficient. Because this money saved comes out of the pockets of traditional middlemen, they are often demonized by both non-HFT players in the financial industry (who see them as competitors) and people outside the financial industry (who don't understand what they do but stigmatize anything related to the financial industry).
posted by pravit at 11:10 AM on January 25

Financial professional here. I'll try to answer each of your questions in turn:

My question then is, who benefits from the toils of the lowly hedge fund manager, other than the manager themselves?

In general, nobody. Hedge funds underperform their indices remarkably consistently - or in other words, you'd usually do better picking a random basket of stocks than investing in a hedge fund. This holds true for most actively-managed (i.e. actual humans picking stocks) investment funds.

Is there any benefit, other than increased profit, that follows from this endeavor (HFT)?

As notyou mentioned, high-frequency trading can provide increased liquidity... but on the other hand, that's probably not a big deal. HFT firms are trading on markets that are already extremely liquid. It's hard to see the benefits of additional liquidity outweighing the obvious downsides.

Is the financial system just a whole bunch of people making money to make money?

Some parts of it, sure. That said, "the financial system" isn't monolithic; some parts of really are widely beneficial. To wit:

1) If you want to invest in a business venture in the hopes of future returns, it provides an easy way to do that. This isn't just for the rich, either - pension funds are some of the biggest players in financial markets.

2) If you need to raise capital for some kind of business venture, selling equity (shares) in your venture is an easy way to do that.

3) It allows individuals and companies to insure against some forms of risk. If you will be especially affected by price movements for certain things (currencies, commodities like oil or various foods, inflation, even weather), you can purchase financial instruments that will hedge that risk for a price. Look into futures contracts if you want to learn more about this.
posted by ripley_ at 11:17 AM on January 25 [5 favorites]

From a Marxist standpoint, finance is the "second circuit of capital" and has its own logic separate from the first circulation of capital which is used to produce commodities: houses, food, and terrible Hollywood sequels.

My interest in finance first got piqued (like many) after the 2008 mortgage crisis (This American Life's episode "The Giant Pool of Money" is a fantastic primer on the whole thing). Your Ye Old Neighborhood Bank that used to directly lend the money for mortgages was a form of financing -- excess capital provided by depositors could then be lent to people taking out loans for Our Starter Home. But the logic of the global pool of excess capital is quite different -- the particularities of the borrower are subsumed into abstractions.

ripley_ is right that the financial system (and all the money sloshing around) is beneficial when you are trying to raise capital for some kind of major venture. Cities rely on being able to borrow big chunks of cash for infrastructure, schools, etc, in the form of municipal bonds. But municipal governments are also held hostage to bond rating agencies whose ratings affect city budgets, the hiring of police/teachers/all city workers, pension benefits, etc. From a NYT piece back in 2008
“We are learning essentially that the emperor may have no clothes, that there is no real reason to require these towns to have insurance in many instances,” said Richard Blumenthal, the attorney general of Connecticut, who is investigating the ratings firms on antitrust grounds. “And it simply serves the bottom lines of the ratings agencies, the insurers or both.”
posted by spamandkimchi at 1:27 PM on January 25 [1 favorite]

We all benefit from fund managers. They play a large role in setting stock prices that make some kind of sense -- so that failing companies have low capitalization and successful companies have high capitalization.

Then you and I can invest in an index fund, and we automatically invest more in the more successful companies. Their stock goes up, and we all benefit. Over a lifetime you can double or triple your money. This is very important for a lot of people now that other paths to wealth (like real estate) are closed off.

I think fund managers are vastly overpaid, and a lot of their work is in conning stupid rich people into giving them their money. But I do benefit indirectly from their existence.
posted by miyabo at 1:49 PM on January 25 [1 favorite]

One thing to consider, which is something I remind myself frequently as an anti-capitalist who also likes her iPhone and her Netflix and has a job that basically could not exist in any society on earth before the last century, is that complex financial markets make our modern day consumer culture possible.

Without the concept of "stocks", Europeans could never gone exploring and looking for spices and Asian trade routes. (Which, OK, there's a huge downside to that, but it's a good example.)

Without the concept of things like checking and credit and money as a sort of virtual concept rather than hard metal, settlement patterns in the US would look very different, simply because it was difficult to move hard currency long distances overland.

On the other hand, there are huge downsides to all of this, especially from ethical standpoints. Maybe Europeans shouldn't have ever gotten on those boats to the Spice Islands. Maybe we should never have built railroads and telegraphs that made it possible to settle most of the continental US. But financial markets enabled all of those things, so if you like those things and think they are good, you sort of have to accept the finance system we have today.
posted by Sara C. at 2:00 PM on January 25 [2 favorites]

Most fees, charges, and commissions that make up the earnings of the financial industry are unnecessarily spent by their customers. Most people would be better off in low fee passive index funds. Wall Street creates products to make money and creates an air of sophistication to scare people into thinking they need Wall Street. There is little value added. There is lots of transfer of wealth. It's inefficient because it's creating income and power disparities that are economically harmful.
posted by Dansaman at 5:52 PM on January 25 [1 favorite]

Here's one way to think of it: in the case of fund management, if they really added value, shouldn't they be able to give you some kind of guarantee about what you are getting in return for the cost of using their services? They won't do that and they can't do that, the reason being not only that they are legally precluded from making such guarantees but also because they know they would never be able to honor such guarantees. Why pay for managed investment services that with good possibility may have a lower return than pay the much lower fees of passive investments? Going with what's certainly better, which is a lower fee instead of a higher fee, is a more rational decision than paying a higher fee that "might" have a better return, unless you've been brainwashed or otherwise led to believe that you need the services of a professional investor because you are not educated or sophisticated enough to understand their magic formulas and fancy math. So again the answer to your question is the financial industry benefits, not the consumer of their services or the economy.
posted by Dansaman at 3:27 PM on January 26

Think about the finances of your own household. In theory, you should pay cash for your car. To do otherwise requires renting money (aka taking out a loan) and paying interest for the privilege. Yet only 12% of cars are bought with cash, because most people don't have the necessary cash flow. Now, imagine if there were no banks. What would be the result? One, cars would be cheaper, since there would be a much bigger market for cars that are cheap, but they'd also be a lot crappier, for the same reason. Two, the young and poor who couldn't even afford a junker car would cause huge demand in car rental and alternatives. Think gypsy cabs and rent-a-wreck places galore. Finally, there would also probably be a huge black market in car loans. Your neighbor (or neighborhood loan shark, more likely), would buy the car in her name and "lend" it to you, probably on terms that we would consider extortionate. It would pretty much be a disaster. If it sounds like a third world country, that's probably because effective financial systems are one of the most important differences between rich and poor countries.

Now, imagine the power a landlord would have in a world without home loans. You can replay this story over and over again, with everything from pension funds to keeping cash in your mattress to life insurance. A world without financial institutions would be difficult, inefficient, and have a shocking robbery rate. Informal, unregulated bank substitutes would step in long before we got to that point.

And we're just talking personal finance so far. Businesses rely on credit even more than individuals. They lease everything. Steve Jobs and Steve Wozniak financed their very first computer by buying a bunch of parts on credit and selling the resulting product before the payment was due. Finance is truly the the lifeblood of the comfortable world that most Americans enjoy.

The question, really, is what price the financial industry exacts for its benefits. Its size, as a fraction of the whole economy, has more than tripled since 1948. Banks looking for higher fees and pension funds looking for higher returns more or less crashed the whole economy a few years back, yet no one is in jail and almost all of the banks got bailed out. The industry as a whole seems dead-set on taking huge risks that result in huge profits some of the time and letting taxpayers handle the losses. That's the current price. The benefits are real and important, but the current price is just too damn high.
posted by wnissen at 4:28 PM on January 26 [2 favorites]

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