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> The function of the capital markets is to allocate capital. I never fully grasped this idea. I have no problem understanding that venture capitalists, angel

by sysk 8y ago

> The function of the capital markets is to allocate capital. I never fully grasped this idea. I have no problem understanding that venture capitalists, angel investors or investors that buy shares at IPO do allocate capital. However, why is trading existing shares considered "allocating capital"?

tedsanders 8y ago
Every purchase of a share rewards the previous owner with some cash. Follow that chain of trades backward and eventually you end up rewarding the founder, the early employees, the VCs, etc. It's a long, tenuous chain, but it's there. I agree with the general point that most trades of mature companies don't seem to have a material effect on the expectations of today's founders, early employees, VCs, etc. Though in theory if liquidity dried up enough or valuations fell, those signals would noisily backpropagate through prices and shift expectations of rewards.
- sysk 8y ago
  I understand the concept of liquidity and the reward mechanism you describe but it doesn't ultimately answer my question, which why is the process of buying an existing share called "capital allocation"? Let's say I buy a GOOG share from Larry Page. Is it the idea that I "allocated capital" to Larry Page's bank account? It seems to me like the correct thing to say would be that I provided liquidity to Larry, not that I allocated capital. Or is it the idea that I allocated some of my own capital to the stock market?
  - roenxi 8y ago
    Two points, one going to your question and one is of general interest. Buying existing shares is "capital allocation" with respect to the _buyer's capital_. So I might allocate 20% of my capital (ie, gross financial worth) to being in shares of some company. The seller is allocating their capital somewhere other than the share. So you allocate your capital to GOOG, pay Larry and notify Alphabet that you are one of their capitalist overlords. If the price of Alphabet stock goes up, you now have more capital even though if you do a quick count you'll discover you have no new currency/cash. The reason this is important is that the people with a good ability to allocate capital will end up with more capital hence control. Eventually, the people in charge will be the people with a good grasp of what is changing (which I'll claim is desirable with no support). For general interest, I've no insight into the intricacies of the US system, but in Australia every so often a company creates and sells new shares directly on the market. The upshot of this is a company can access the market directly for capital.
deleted 8y ago
[deleted]
coltonv 8y ago
This is one thing that frustrates me about investing in the stock market. The idea of calling trading "investing" feels so inaccurate. I didn't invest in your fortune 500 company, I bet on the idea that other people down the line would bet on the same company but that they'd bet even harder. I wish investing was more like selling small corporate loans. I'll give Amazon $50 today if they pay me $100 in 10 years. Sounds great to me, take my money, do something with it, and pay me back. That's investing. I've grown much more comfortable investing in real estate as a result of this. When I invest in something I want to see how that investment was used, how it helped, and get returns based on how successful my ideas were. If I renovate a house or invest in my buddy's business, I get exactly that. It may fail, but at least my money mattered and I saw what it did to help. When I invest in the stock market I get none of this.
- ISL 8y ago
  Sounds like the bond market is right up your alley; that's how bonds work. (N.B. read first, invest later.) The thesis above also neglects dividend investing, where you buy a share of Ford Motor Company from someone for ~$9, and as long as Ford can do so, they'll probably give you $0.15 every quarter.
- taurath 8y ago
  >I wish investing was more like selling small corporate loans. I'll give Amazon $50 today if they pay me $100 in 10 years. Sounds great to me, take my money, do something with it, and pay me back. That’s a bond. Corporations do issue bonds but it’s just one way to invest, and generally you’re just betting they’ll pay their debt to you (and you’ll tend to get less over time but it’s more guaranteed). With a stock you’re betting that the value of the company will increase over time and you get paid as it increases in size and income.
  - eldavido 8y ago
    This is basically Warren Buffett's conception of a stock: a bond with a variable interest rate. It gets easier when you think of a share as a fractional claim on a cashflow (profits - what's "left over"). Bondholders are generally promised a specific amount upfront. Stockholders get what's left over -- the amount of that is anyone's guess. It gets pretty abstracted when you start talking about firms that don't pay out profits but the basic idea is sound.
nostrademons 8y ago
It's a price mechanism. The logic is that by having a liquid secondary market where investors are free to trade securities whenever they want, you always have an up-to-date price that reflects all information known about future prospects for that business. (If you didn't, then someone with superior information could trade based on that and reap a profit, which increases the amount of capital they have to trade on in the future, which means that eventually all the capital ends up in the hands of the firms with the best information.) Then whenever a company needs capital for future expansion - whether it be for secondary stock offerings, new factories, or stock options to entice key researchers or executives - they have an accurate price on the stock with which to judge the cost of capital. If their stock price is low and capital expense is high, they may decide that the capital investment won't increase the value of the company enough to be worth it; the market has prevented capital from flowing to inefficient businesses. (Again, if they guess irrationally, they go out of business, and the system remains rational even if management isn't.) Similarly, if the market puts a high price on the stock because there's a belief that what they're doing is important and will reap big rewards in the future (eg. Tesla), they'll find it cheaper to make big capital investments. The early-stage startup financing market - angels and VCs - is actually both quite illiquid and quite inefficient - prices at that stage are basically just guesses, which is why some companies rapidly increase in value and many others go to zero. It too depends upon the liquid secondary market after IPO to keep actors rational, though - if VCs could not sell their shares later on the public markets, they would have no incentive to invest in startups.
- sysk 8y ago
  Thanks for the elaborate reply but I was aware of all of this already. I wasn't questioning the utility of the stock market and understand its role as a price discovery mechanism and liquidity provider. I was however questioning whether this sentence from the article was really accurate: "The function of the capital markets is to allocate capital". I'd argue that trading existing shares, although it contributes to price discovery and liquidity, is not "capital allocation" (unless we're talking with respect to the buyer's capital like another commenter pointed out).
  - 8y ago
forkLding 8y ago
One possible way is if we consider capital allocation in terms of acquisitions, where one company acquires other companies by giving them stock instead of cash (which is what a lot of pre dot-com era telecom companies did to acquire customers + coverage like Verizon or the notorious Worldcom) and the ease of those acquisitions was largely based on the demand of that stock and thus the stock price.
AnthonyMouse 8y ago
> However, why is trading existing shares considered "allocating capital"? Because the company is made of capital. It has a plot of land with a factory, equipment for making brake pads, raw materials, a trade name that engenders goodwill with customers etc. When you buy a share, that share of ownership of the capital is allocated to you. You get a vote in how it's used. You could vote to keep making brake pads as ever, or mortgage the factory to expand into brake rotors, or cease operations and sell the individual assets to the highest bidder. In principle you could be the deciding vote and someone else could have made a different decision than you.
- sysk 8y ago
  Ah, it makes a bit more sense when interpreted that way. So the capital that is described as being allocated is really the company's capital to the investor, not the investor's cash to the company.
C1sc0cat 8y ago
If I buy shares in a company say RDSB (Shell) I am allocating my capital to that company and someone else is selling theirs as they don't want to own that asset any more. I did this when the share price was low so I was taking a long term view that it would recover and I would capture that value and also have the dividend at an expressed yield on between 6-7%.
nicholas73 8y ago
A functional capital market provides liquidity and higher valuation to an investment. Without these two you would have less capital going into companies. Trading shares may have little immediate effect, but certainly do for the next share offering.

by sysk 8y ago

tedsanders 8y ago

Every purchase of a share rewards the previous owner with some cash. Follow that chain of trades backward and eventually you end up rewarding the founder, the early employees, the VCs, etc. It's a long, tenuous chain, but it's there. I agree with the general point that most trades of mature companies don't seem to have a material effect on the expectations of today's founders, early employees, VCs, etc. Though in theory if liquidity dried up enough or valuations fell, those signals would noisily backpropagate through prices and shift expectations of rewards.

sysk 8y ago
I understand the concept of liquidity and the reward mechanism you describe but it doesn't ultimately answer my question, which why is the process of buying an existing share called "capital allocation"? Let's say I buy a GOOG share from Larry Page. Is it the idea that I "allocated capital" to Larry Page's bank account? It seems to me like the correct thing to say would be that I provided liquidity to Larry, not that I allocated capital. Or is it the idea that I allocated some of my own capital to the stock market?
- roenxi 8y ago
  Two points, one going to your question and one is of general interest. Buying existing shares is "capital allocation" with respect to the _buyer's capital_. So I might allocate 20% of my capital (ie, gross financial worth) to being in shares of some company. The seller is allocating their capital somewhere other than the share. So you allocate your capital to GOOG, pay Larry and notify Alphabet that you are one of their capitalist overlords. If the price of Alphabet stock goes up, you now have more capital even though if you do a quick count you'll discover you have no new currency/cash. The reason this is important is that the people with a good ability to allocate capital will end up with more capital hence control. Eventually, the people in charge will be the people with a good grasp of what is changing (which I'll claim is desirable with no support). For general interest, I've no insight into the intricacies of the US system, but in Australia every so often a company creates and sells new shares directly on the market. The upshot of this is a company can access the market directly for capital.

deleted 8y ago

[deleted]

coltonv 8y ago

This is one thing that frustrates me about investing in the stock market. The idea of calling trading "investing" feels so inaccurate. I didn't invest in your fortune 500 company, I bet on the idea that other people down the line would bet on the same company but that they'd bet even harder. I wish investing was more like selling small corporate loans. I'll give Amazon $50 today if they pay me $100 in 10 years. Sounds great to me, take my money, do something with it, and pay me back. That's investing. I've grown much more comfortable investing in real estate as a result of this. When I invest in something I want to see how that investment was used, how it helped, and get returns based on how successful my ideas were. If I renovate a house or invest in my buddy's business, I get exactly that. It may fail, but at least my money mattered and I saw what it did to help. When I invest in the stock market I get none of this.

ISL 8y ago
Sounds like the bond market is right up your alley; that's how bonds work. (N.B. read first, invest later.) The thesis above also neglects dividend investing, where you buy a share of Ford Motor Company from someone for ~$9, and as long as Ford can do so, they'll probably give you $0.15 every quarter.
taurath 8y ago
>I wish investing was more like selling small corporate loans. I'll give Amazon $50 today if they pay me $100 in 10 years. Sounds great to me, take my money, do something with it, and pay me back. That’s a bond. Corporations do issue bonds but it’s just one way to invest, and generally you’re just betting they’ll pay their debt to you (and you’ll tend to get less over time but it’s more guaranteed). With a stock you’re betting that the value of the company will increase over time and you get paid as it increases in size and income.
- eldavido 8y ago
  This is basically Warren Buffett's conception of a stock: a bond with a variable interest rate. It gets easier when you think of a share as a fractional claim on a cashflow (profits - what's "left over"). Bondholders are generally promised a specific amount upfront. Stockholders get what's left over -- the amount of that is anyone's guess. It gets pretty abstracted when you start talking about firms that don't pay out profits but the basic idea is sound.

nostrademons 8y ago

It's a price mechanism. The logic is that by having a liquid secondary market where investors are free to trade securities whenever they want, you always have an up-to-date price that reflects all information known about future prospects for that business. (If you didn't, then someone with superior information could trade based on that and reap a profit, which increases the amount of capital they have to trade on in the future, which means that eventually all the capital ends up in the hands of the firms with the best information.) Then whenever a company needs capital for future expansion - whether it be for secondary stock offerings, new factories, or stock options to entice key researchers or executives - they have an accurate price on the stock with which to judge the cost of capital. If their stock price is low and capital expense is high, they may decide that the capital investment won't increase the value of the company enough to be worth it; the market has prevented capital from flowing to inefficient businesses. (Again, if they guess irrationally, they go out of business, and the system remains rational even if management isn't.) Similarly, if the market puts a high price on the stock because there's a belief that what they're doing is important and will reap big rewards in the future (eg. Tesla), they'll find it cheaper to make big capital investments. The early-stage startup financing market - angels and VCs - is actually both quite illiquid and quite inefficient - prices at that stage are basically just guesses, which is why some companies rapidly increase in value and many others go to zero. It too depends upon the liquid secondary market after IPO to keep actors rational, though - if VCs could not sell their shares later on the public markets, they would have no incentive to invest in startups.

sysk 8y ago
Thanks for the elaborate reply but I was aware of all of this already. I wasn't questioning the utility of the stock market and understand its role as a price discovery mechanism and liquidity provider. I was however questioning whether this sentence from the article was really accurate: "The function of the capital markets is to allocate capital". I'd argue that trading existing shares, although it contributes to price discovery and liquidity, is not "capital allocation" (unless we're talking with respect to the buyer's capital like another commenter pointed out).
- 8y ago

forkLding 8y ago

One possible way is if we consider capital allocation in terms of acquisitions, where one company acquires other companies by giving them stock instead of cash (which is what a lot of pre dot-com era telecom companies did to acquire customers + coverage like Verizon or the notorious Worldcom) and the ease of those acquisitions was largely based on the demand of that stock and thus the stock price.

AnthonyMouse 8y ago

> However, why is trading existing shares considered "allocating capital"? Because the company is made of capital. It has a plot of land with a factory, equipment for making brake pads, raw materials, a trade name that engenders goodwill with customers etc. When you buy a share, that share of ownership of the capital is allocated to you. You get a vote in how it's used. You could vote to keep making brake pads as ever, or mortgage the factory to expand into brake rotors, or cease operations and sell the individual assets to the highest bidder. In principle you could be the deciding vote and someone else could have made a different decision than you.

sysk 8y ago
Ah, it makes a bit more sense when interpreted that way. So the capital that is described as being allocated is really the company's capital to the investor, not the investor's cash to the company.

C1sc0cat 8y ago

If I buy shares in a company say RDSB (Shell) I am allocating my capital to that company and someone else is selling theirs as they don't want to own that asset any more. I did this when the share price was low so I was taking a long term view that it would recover and I would capture that value and also have the dividend at an expressed yield on between 6-7%.

nicholas73 8y ago

A functional capital market provides liquidity and higher valuation to an investment. Without these two you would have less capital going into companies. Trading shares may have little immediate effect, but certainly do for the next share offering.