As Michael Lewis, former trader and bestselling author, says, “The stock market is rigged”.
In this 60 Minutes Show interview Michael Lewis goes on to explain how the stock exchanges, banks and high frequency traders are rigging the markets in their favour. He explains how high frequency traders have paid for a privileged access to the stock exchanges so that they can see and place orders before other investors. This allows the high frequency traders to front run the orders of other investors. As Michael says:
“[High frequency traders] are able to identify your desire to buy shares in Microsoft and buy them in front of you, then sell them back to you at a higher price. It all happens in infinitesimally small periods of time.”
This advantage given to high frequency traders is making them millions of dollars in profit each year — and is sucking profit from every other investor in the market.
This type of market rigging is bad — but take a step back and you’ll see there is a much bigger problem.
It’s all about incentives
Financial Markets are incentivising and rewarding the wrong types of behaviour. The reason markets exist is to connect those with excess capital with those who are in need of funds. The purpose is to efficiently allocate resources so that the economy can run to its potential, increasing GDP and (in theory) benefiting everyone in the economy. In contrast, the way incentives are misaligned in modern financial markets has a knock-on effect that means companies all over the world are encouraged to maximise profit and growth at all costs. Cost to society, cost to citizens, cost to taxpayers.
To see why this is the case, we need to follow the incentives in financial markets…
Generally speaking, investors are always chasing the highest return possible over a given period. Fund managers therefore have a duty to invest in companies that they believe will lead to the greatest return for their investors. And notoriously, company leaders have a duty to maximise shareholder returns. Whether or not this is a legal obligation is often debated but the mantra is frequently repeated by the press and by business — and regardless of the legal status, it is clear that CEOs are lorded when share prices are increasing.
What is the cost?
This dogmatic quest to increase company stock prices at all costs has led to countless situations where, in order to chase profits and boost share prices, leaders have taken asymmetrical risks: if it all goes to plan the company makes money, if something goes wrong then society pays the cost.
Each of these crises was a byproduct of a company culture that stemmed from chasing profits at all costs. Each of these crises ended with a huge cost to either the environment, the taxpayer or both.
Regulators around the world respond to such scandals by increasing regulation, and while the intention is in the right place, these knee jerk responses often cause even more harm to the end investor. This is because complex regulation creates distortions that lead to both market inefficiencies and fuel a payoff for companies that decide to prioritise lobbying government in their favour.
Financial markets are broken, and regulation isn’t fixing them.
There is hope!
A solution with potential to fix our broken financial markets lies in the flawed logic that investors are demanding high returns, forcing fund mangers to invest in only the fastest growing stocks and forcing company leaders to take reckless gambles in search of higher profits. The flaw, of course, is that investors care about much more than just high returns.
Investors are human beings. They are workers saving for a pension, they are parents saving for a college fund, they are millennials fed up with low rates on their savings accounts. Investors are people like us who exist in the real world; a world with wildlife, a world with communities, a world with externalities. This world is complex and as people our utility functions are multi-dimensional: we care about much more than just profit maximisation. We care about having clean air to breathe and green spaces to enjoy. We care about low crime and good quality schools. We care about freedom to be ourselves and living without discrimination. The list goes on.
But while it is obvious that people (and thus investors) care about more than just profit maximising, the financial markets that we have built to allocate resources for us are single-minded. And so they need updating.
I propose that financial markets must be updated to take into account investor preferences beyond just profit maximisation. Stock prices must take into account all the other considerations that investors are looking for as citizens. Stock prices must incorporate sustainability.
If a stock’s price can incorporate the sustainability of a company as well as the company’s financial health then incentives are realigned. Investors who express their multi-dimensional view by buying a stock they believe in will be rewarded as the stock will move based on the company’s expected profit and how sustainable they are. This, in turn, will motivate leaders of public companies to chase more than just profits — but to consider how their actions are affecting the world in which we all live.
And so I propose an alternative version of a stock price: the Sustain price. Coined by Andre, the Sustain price is a company’s stock price adjusted for the firm’s impact on the world. This impact is measured in many ways: how the company treats the environment, how the company regards its employees and how the company works with its communities — to name a few.
More to come. Watch this space.
Call to Action
Do you have any thoughts on anything discussed here? Does anything anger you? Excite you? Bore you? Let me know your uncensored reactions in the comment section below.
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