Red Stones and Why People Trade

(i) This is an old article (year 2000) taken from a newspaper: an excerpt from a book being printed on the newspaper. I typed and saved it to one of my now-defunct web page on investment and pension planning.

(ii) I don't know what part you might need further explanations, so I won't put down any. Instead I will try to answer any query you might have. Leave your questions here and I will try to answer them as best I could.

Red stones, and why we trade

By Paul Kedrosky, professor of business at the University of British Columbia, Canada. Article as appeared in the National Post , in year 2000



  On Tuesday of last week, trading was so frantic that a tired Toronto Stock Exchange counted itself out two minutes before the closing bell.(i) Last Wednesday, more stocks traded on the TSE than in all of 1949. Two days like Wednesday would have accounted for all of the TSE's 1977 trading volume.

(i) A bell is "hit" at 9:30 to start the trading (opening bell), and at 4:00 p.m. to stop the trading (closing bell).



Rather than complain about all the volume, let's look at why it happens. Why do stocks trade? It is interesting to kind of back into an answer.

Imagine you have a red stone, and you think it's worth $5. Imagine you know four other people who have the same red stone, and they all think their red stone is worth $5 too. Now let's say that all five of you have only $3 left after buying red stones. Assume that there is no one else around, and you have food, water and shelter, so pretty much the only thing you're left wanting is more red stones.

What would happen?

All else being equal, nothing. After all, if no one has enough money to offer $5, and if everyone thinks red stones are worth $5, why trade?

So how could we kick-start the market? New money would certainly do it. If any of the five rock-lovers discovered a couple more dollars in a back pocket, they could offer $5 for a red stone and get another stone. There might be a ripple of trading as that influx of capital moved around the market, but it wouldn't last long: Prices would increase slightly, and once again trading would stop. To keep it going, you need an ongoing source of new money.

There is another way to get things going: You could convince someone else that a red stone isn't worth what they thought it was. To do that, you might rely on your rhetorical skills and argue someone into the ground: "Red stones? Pshaw!" But that is tough. Better yet would be to start a rumour that somewhere nearby there was a huge cache of red stones, all soon to arrive on the market. And when they did, you'd suggest, the value of red stones would drop like a ... stone.

Some holders of red stones are likely to be rattled. They would worry that if they didn't sell their red stones now, they wouldn't be worth $2, let alone $5. Depending on how many people believed your red-stone-glut story, the trading could be orderly, or it could get frenzied. You would be able to buy at least one red stone, and possibly more.

So far, this has covered off at least two reasons trading happens. There is the arrival of new capital -- which can take the form of new people or more money among participants, or both -- and valuation worries. Either way, there is at least some trading, with commensurate price increases until trading dries up -- or until the price collapses and people lose interest in red stones and move on to green ones.

There remains an unexplained paradox in my description. Put it this way: If we all think red stones are worth the same amount, then no trading should happen. That is because I would not be willing to part with my red stone so long as I'm not getting the value I want, and you would not be willing to offer that amount, because it is your value too.

And what if we went in the opposite direction? What if we all decided at the same time that red stones weren't worth much? In that case, the value of the stones would fall and we'd all happily part with them for much lower prices. Trouble is, who would the buyers be? We would need new people to enter the market if we were to have any chance of unloading our red stones.

Markets need nervousness and uncertainty to work. An old expression used by traders says the same thing: "The market climbs a wall of worry." As long as there are things that rattle investors, then people will sell their stock to new entrants or to other players in the market. News promotes trading.

You hear that Company X is introducing Product Y and you think it validates the business of Company Z, whose stock you hold; I think it's a sign of increasing competition and sell my Company Z stock -- which you happily buy. As long as there are things to worry about -- rising interest rates, stock valuations, and on and on -- there will be trading.

Because unlike in my red stones example, when we agree on something in the real market, it does strange things to share prices. If we all agree that the market is heading south, then stocks will drop precipitously, as crashes and panics have shown repeatedly. Same thing in a less dramatic way in the opposite direction: if we all agree stocks are going up (and that kind of agreement is very rare), prices will leap up in great stability-destroying steps.

It is one of the essential perversities of the stock market. As long as there are things that convince some people to sell and other people to buy, the market keeps ticking right along: Disagreement is at the core of the market. Strangely enough, it is only when we agree on anything and things seem smooth that the market gets itself into trouble.