Why Stocks and Bonds Exist

The story of stocks and bonds is that of entrepreneurship. In the United States alone, over 500,000 new businesses are started every year. I suppose, having a “boss” is not an easy thing for many people.

A popular US Army recruiting slogan created in 1980. It was changed to “Army of One” just before the real wars began in Afghanistan and Iraq.

If anything, the urge to start businesses is stronger than ever before. A recent survey of millennial college kids showed that roughly 2/3rd of them would like to be entrepreneurs – to “be all that you can be” in the words of Uncle Sam above.

It is commonly thought that the big hurdle in starting a business is having a great idea. That is not quite true. The big problem entrepreneurs face is not the idea but raising money. There are legions of great ideas that failed for lack of funding and many mediocre ones that succeeded because capital was available. Financial markets exist to sort all this out.

There are two (legal) ways to raise money aside from selling your wife’s jewelry (or your husband’s vintage cigar collection). You can (a) borrow money from a lender or (b) sell a share in the future profits from your business. In both cases, you get cash from the investor in exchange for some sort of a future “claim”. When you borrow money, the investor claims the future payments you will make to pay off the loan. This type of claim is a “bond”. If, on the other hand, you agreed to share future profits with your investor, he will eventually show up to claim those. This is called a “share” or “stock”.

Bond-like claims are less risky from the investor’s point of view. The reason is this: borrowed money has to be repaid even if the business doesn’t make any money. Your lender has the legal right to recover his money by selling your business assets such as machinery, placing a lien on the land etc. He can even force you into bankruptcy proceedings. Stock-like claims, on the other hand, have to be paid only if the business makes a profit.

Stock and bond markets are nothing more than places where claims are bought and sold. The price of a claims tells you something about the entity that issued it. For example, claims on the profits of Google are valuable. Claims on the repayment of debt incurred by the Greek Government are not so valuable. I’m sure you can imagine why!

Through most of human history there were no large organized markets where you could sell claims and raise money. New entrepreneurs typically tried to raise money by approaching a few wealthy people or banks. We still have these of course, e.g. “angel investors” and venture capitalists. Many large states like Texas and California even have angel networks where entrepreneurs pitch their ideas to a whole group of angels at once. This sort of activity is known as “private” markets, because the money-raising that happens is nobody else’s business. You can take all your funding agreements, bury them in a hole in your backyard, and never tell a soul about it. (Do tell the IRS though, they are not big on accounting secrets).

Private markets are great for early stage firms but they fall far short of satisfying the needs of the economy. Once businesses get bigger than a few million dollars, their future expansion needs are beyond the mental and financial resources of the rich class by itself. Besides, even established firms like Microsoft and Apple need money to finance all sorts of growth activity. There are millions of businesses, large and small, all with ideas for the future – it takes a positively gargantuan amount of money to fund them all! Take a look at the figure below:

A snapshot of funding needs of the US economy in 2011. The total requirements of companies, households (mortgages) and the government are much bigger than the capacity of private markets to provide. [Sources: Congressional Budget Office (CBO), Securities Industry and Financial Markets Association (SIFMA) ]
Notice that the funding needs of companies through bonds and stocks add up to $1.2 trillion which already exhausts the entire yearly income of rich households. But we still have to come up with over $3 trillion for the federal and local governments and the $1.7 trillion that ordinary people need to borrow for their home mortgages. Obviously, the “fat cats” are not fat enough!

So, what do we do? Well, there are 150 million people in America alone who go to work everyday, listen to their bosses, get paid and save some money. They need to grow this money to pay for their retirement, college tuition etc. Not only that, there are a lot of people in other countries who would like to invest their money in the US. The savings from all these sources is also a gargantuan amount of money!

“Public” markets bring together the entire saving public and those who need funding. It is as simple as that. Exchanges like the New York Stock Exchange (NYSE) run these public markets so that anyone can go and buy stocks. You can also buy bonds easily through an account at retail brokers like Fidelity etc.

It is a big decision for a company to go public. It can no longer hide its books in a hole somewhere. The financial accounts of public firms have to be disclosed every quarter, so that investors know what’s going on. This is a good thing! It is often said that these quarterly disclosure force public firms to focus on short-term profits rather than the long-term. There is some truth to that, but the advantages of transparency far outweigh any short-termism among the CEOs. Almost all major firms in the world are public, with few exceptions.

A good example of an exception is Koch Industries, one of the largest private firms in the world. If you have never heard of it, I’d invite you to casually search for news items on this firm. It will convince you that there isn’t much enthusiasm about the secret accounts of this 100 billion-dollar business!

Like everything public, public markets are also regulated by a Government agency. The Securities and Exchange Commission (SEC) is charged with setting ground rules for the marketplace and investigating fraudulent activity. To be very honest, the SEC does not have anything close to the resources needed to keep an eye on the trillions of dollars that are traded everyday. But, the occasional problem or fraud aside, public markets manage to function quite well. In fact, they have brought about a revolution in human affairs. For most of history, it was just the rich people who invested in new businesses because markets were private. The common person had little opportunity to grow their money. Unsurprisingly, most people were just poor peasants, dragging their sorry lives from one generation to the next. It is only for the past 40 years or so that the western world has embraced the idea of meeting most public funding needs like new businesses, mortgages, car loans, government etc through the savings of the population as a whole.

In a sense, these public markets are your markets in the same way as a public park is your park. They exist to serve a public purpose which is to allow ordinary folks to invest and public firms to raise money.

Here’s another thought – since public markets are all about raising money, then it follows that a market “crash” implies future difficulties in raising money. Indeed, when stock markets fall it does become hard to raise money by selling shares  and when bond markets fall it becomes hard to borrow money from lenders.

The whole concept of diversification, which we will talk about some other time, is related to figuring out who can raise money in any given situation and how.