Do traders and investors add value to the society, or at least the financial ecosystem? In order to make money, one must provide value. If there are traders and investors out there that make money, there must be value that they contributed. I could think of 5 contributions.
Bring prices closer to ‘true value’
Instead of believing the market is always efficient, investors and traders buy and sell to price the market as efficient as possible. Most of the time, traders are able to move price closer to the true value. But when the orders become overwhelming, that is where the market goes out of whack. No hedge fund or bank would be able to fight against the crowd in unison.
A value investor will look for an asset that is priced lower than the ‘true value’. So by buying the assets, the demand he created signals the market that the price is wrong and it has to go up. Likewise for traders, they will be rewarded for getting the asset back to the true value over a shorter horizon, by altering the supply and demand in the market.
Help society allocate resources
Companies need funds to expand their operations. One of the ways to raise money is to be listed and sell part of the companies to investors. Investors who see potential in the company would provide resources (money) to the company to grow. This is also true for commodities. Suppose more and more people are moving into the cities to work in office and there is a declining trend in farming. Production of crops, let’s say corn, reduced. Over the years, supply of corn drops and demand would increase due to population growth. Traders and investors who sees the trend would buy corn contracts and the demand will drive the corn prices up. The rise in corn price will encourage farmers to produce more corn, until the supply matches the demand and price would stabilize.
Improve liquidity
A transaction requires a buyer and seller to agree on a price. Traders and investors provide a ‘service’ by being the counter-parties. With a good pool of buyers and sellers, the marketplace become vibrant and it is easy for a buyer to find a seller and vice versa. The exchange is able to match buyers and sellers of different contract sizes and transact as much as possible. Imagine we have person A who wants to sell 5,000 shares, person B wants to buy 7,000 shares, and person C wants to sell 2,000 shares. Person B can buy from both person A and C. This is a simplified example and as more traders and investors participate in the market, the easier for the transactions to go through.
Liquidity also means that the spread between buying and selling assets will narrow. Spread is the difference between the buy price and sell price.
Transferring risks
By buying assets, traders and investors are assuming risks. Just like insurance companies, they guarantee a sum of money upon deaths. They took on the risk and we are willing to pay them for that. Especially in commodities, producers and consumers do not like the uncertainty of future prices. As such, they use futures contracts to lock in the prices for the future delivery of commodities. Traders and investors would assume the risk of uncertainty and get rewarded if they are right and lose money when they are wrong.
Provide livelihood for the financial industry
Today’s financial industry has become sophisticated. It takes great cost to run a complex system. Traders and investors, through the buying and selling of assets, paying the transaction costs, help to support this financial industry. Without transactions, the financial industry cannot sustain an extensive number of brokerage firms and operations.
What other values do you think traders and investors contribute? Or do you think that traders and investors do not contribute at all?
Posted in: Nature of Financial Markets
No comments:
Post a Comment