Lately, everything I look at is going up. I look at stocks of tech companies in US and they are going up. I look at various stock market exchange indexes and they are going up, both in India and in US at least. Crypto-currencies are going up for the last year or so. And not just up, some of these assets are going up in a crazy fashion, doubling 10x in a year. It was becoming hard for me to even understand what I was doing and made investing even more risky.
For a long period of time, until recently, I used to believe that net result of every transaction is 0. If you are spending money, someone is earning money. So if you make money in the stock market, someone should be losing money. That is what the conventional wisdom in my head said.
But one of these days recently I was wondering if it is possible this is not true and I spent 30 minutes trying to play out scenarios when this might not be true. Turns out, I was WRONG. Transactions on stock markets, transactions on various assets including house prices, crypto or gold do not have to be a net 0 result. Let me explain why:
Let’s say there is a company X with 100 stocks, 1 each issued to 100 stock-holders. At the time it was created they valued the company at $1 per stock and hence the total wealth among these people is $100.
One month later, there was an offer (on a stock exchange) to buy stocks in this company X for $3. If 2 of the shareholders sold their stock, they made money (a profit of $1). The person who bought the stock has not yet lost any money. And the stock price goes up to $1.5 (mid-market price of buy/sell offers). So suddenly, with no one losing money, the wealth increases to $150 (among all stock holders).
Keep moving forward in time and repeating the same process and you realize that $1 stock can go to $100 without anyone losing money. Perhaps this is what is happening in crypto-currencies. As long as someone is willing to buy at a price higher than I bought for, no one has to hypothetically lose money.
That said, in real world, people do lose money. But they do not have to lose money in order for someone to make money. People lose money because of the general faith in company going down or market panic etc. Since human beings are naturally loss averse, it makes sense that people will try to hold on to stock if the price goes down and sell it when they make a profit. That means that it is more likely prices of assets will keep going up in most cases unless major events happen worldwide, for the company or its environment.
House prices in general have gone up continuously and yet very few people lose money on house transactions. That’s just one example and I feel like literally anything we value as an asset has a higher probability of increasing in price than decreasing in price.
The other thing I realized while thinking about this is what is called pump and dump. It is the practice of price manipulation if you have out-sized asset holding or money. This is how it works:
In the same example as above, let’s say I decide to go to stock market with $500 and try to buy as much stock of company X as possible. I slowly try to accumulate 50 stocks of the company (out of 100) by starting buying at $2 and increasing my offer. At $5, I am able to buy out 50 stocks in total . At the same time, other participants in the market see the price of this hot stock that has gone from $1 to $5. They get interested and want a piece of action so they start buying as well. As this happens the price may further increase to $6 or $7. I decide $2 is good profit for me, so I start selling all my holdings at $7 and keep selling until I have nothing left. In the whole process, I would have made more money that I paid for each stock on average. And hence the term, pump and dump.
I guess it is fair to say, money attracts money. The more money you have, the more money you make. And hence I wonder if we will ever see a major correction in crypto-markets. For a major correction to have happen, people must want to sell at a lower price. A lot of people in crypto-boom, just bought and now hold this currency. They do not have an interest in selling, they are just doing it for the novelty. And hence unless people lose trust in the technology, it is unlikely that crypto might every go away.