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Stocks Aren’t a Ponzi Scheme

In the last two years, one assertion I’ve heard over and over is that the stock market a giant Ponzi scheme — it only works if everybody continues to feed it money, and it collapses when people take their money out.

A similar assertion is that the stock market is just a “greater fool game,” in which stocks’ only value lies in the hope that you can sell them at a higher price to a greater fool at some point in the future.

Both claims are nonsense.

Stocks Have Inherent Value

If the public at large decided that they wanted nothing to do with stocks, and they all pulled out (and this is, to a lesser extent, what goes on in severe bear markets), stocks wouldn’t become worthless. Yes, they’d be worth less, but not worthless.

For the value of a stock to go to zero, the company itself has to be worthless. As long as a company has intrinsic earning potential, a share of ownership in that company has value as well.

A Worthless, Profitable Company?

For example, imagine if the price of Verizon’s stock declined all the way to $0.01 and that this decline was caused purely by investor panic. That is, it had nothing to do with any fundamental change in the profitability of the company. With a share price of $0.01, the company’s dividend yield (based on its most recent dividend) would be 4750%! Even if the price never went back above $0.01, you could get an obscenely high return from buying at such a low price.

Of course, such a scenario would never occur. The price of a company doesn’t ever go that low unless there’s a fundamental decline in the company’s profitability. At some point, investors would step in to snatch up the high dividend yield, thereby keeping the price from falling further.

Owning, Not Just Selling

Yes, companies’ earning potential can decline, or even go to zero. But it’s not caused by people getting scared.

Unlike a Ponzi scheme or a “greater fool” game, stocks have an inherent value. And they have that value even if there’s no “greater fool” to sell to, and even without investors continually pumping  money into the system.

Now, to be fair, stocks do have a ponzi-ish aspect to them, in that their market value does go down when other people pull their money out. But to assert that stocks’ only value lies in their ability to be sold is simply not true. You can receive value by owning stocks, not just by selling them.

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Comments

  1. Excellent points, Mike. I would only add that a company’s value goes beyond it’s earning potential and includes its assets, too.

    Take your Verizon example. If the price is $0.01/share because of investor panic but the company has millions of dollars in liquid assets (and more than enough to cover debts), then buying the shares not only gives you access to future earnings but also ownership over those assets. You’d have to dissolve the company to get at those assets, but there is certainly more behind the value of that stock price than just earnings or growth potential.

  2. Good point, Paul.

    Sorry your comment was initially flagged as spam. I’m not sure why that happened.

  3. Great points. It’s sad that investors have become so dispirited against stocks and are now flooding into cash and bonds, two asset classes that in the long run will not generate very high returns. A portfolio that is mostly stocks is the only way to generate returns high enough to retire well.

  4. Hear, hear. I almost despair at the nonsense being peddled around the Internet. It may be time to start licensing bloggers.

    To follow on from Rick’s point, many people are skeptical at the wrong times, about the wrong things.

  5. Very true! Stocks have an inherent value and dividend payers will even reward you for waiting. However, because irrational people make stupid decisions regarding stock purchases, many times the stock price is not significantly tied to the underlying value of the company.

    I remember when Google stock kept shooting up, not because of great innovation or great financial reports, but because of investors not wanting to be left out. Those that bought at almost $750 hoping that it would shoot to $800 in a month did so because they expected to find a bigger fool, not because they evaluated the company and thought that $800 was a fair value.

    So I would say that stocks are not a ponzi scheme, but investing in the stock market (judging by the rationale given by many investors) can carry a lot of “ponzi” elements (something that you stated as well).

    @ Monevator, I agree with you that this idea is usually ignorantly thrown out there by people who don’t really understand the issue.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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