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"?
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.
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).
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.
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.
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.
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.
This was unquestionably an investment on his part, in the traditional sense of the word. Our hero bought a productive asset and earned returns from that asset. It was nice that it also appreciated, but that's not necessarily what he bought it for. Or maybe he did. It doesn't fundamentally change the nature of his effort.
Buying a stock is very much like that, with lower transaction costs and risks. Only the productive asset you're buying is not a physical one, but a legal one and social one.
Also, you can buy corporate bonds. They don't pay shit because everyone wants a safe investment like what you're describing, and money is real cheap right now.
You are correct in that there is no net new creation of equity capital in a secondary market trade.
I look at it this way: there is a fixed amount of equity capital floating in the world at any given moment. At any point in time, someone has foregone consumption (decided to forego eating a pizza today), at some point in the past (distant or recent) in order to own a piece of that equity.
Also keep in mind companies issue and retire equity on a more or less ongoing basis through employee stock grants and buybacks. So it really is a question of how much you want cash vs. shares of stock, and how that tradeoff works for others.
This is absolutely not the case.
You just provided a (simplistic) definition of investing. I don’t see how that supports your claim that it’s not investing. All investing is just buying something that you think will be worth more over time. You buy a share of a company because you think the share will be worth more. You buy a bond because you think the issuer will be able to pay back the debt and interest. I can’t think of another definition of “investing.”
Those cashflows may be subject to (negotiated) differences in timing, risk of nonpayment, intrinsic uncertainty (most equities fall into this bucket), etc.
But at bottom it's all just cashflow.
This is a useful lesson to generalize about finance, in the larger sense. Don't think about "worth more". Just think of it as timed cashflows. Negative when you buy, positive when you sell or receive a dividend.
Investing is saying "ok big warehouses for distribution companies like amazon is a growing market therefore I will buy shares in a company that owns warehouses (BBOX) - this is sort of how Warren Buffet works
The stock price does connect to the real world though. If a company is deciding whether to expand, or bring in new management, or exit an industry, their stock price will certainly factor into that. If they're looking to buy another company, or another company is looking to buy them, the stock price is even more relevant.
Ultimately you are betting that the company will one day buy back stock, be acquired, issue dividends, etc.
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.
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.
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.
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%.