Image Source: Pexels

One of the great strengths of the USA is its capital markets. No economy in the world does a better job of getting capital into the places where it can be most efficiently utilized. This is, arguably, one of the stark differences between the US economy and the rest of the world and why the USA has performed so much better over the last 20 years. The USA has an intricate network of banks, non-banks, private equity, and venture capital that tirelessly seeks out the best place to allocate capital. Some people view this “financialization” of the USA as a weakness, but I view it as a strength. No country has a more trustworthy network of financial institutions and allocation of capital than the USA.

While the private markets appear to be getting increasingly efficient a strange thing is happening in the public markets. As companies stay private longer and the private equity markets grow the public markets are increasingly becoming a place where people gamble and engage in negative-sum games that they may not understand as an inherently negative sum.

When I was researching my forthcoming book I spent a lot of time focusing on the difference between insurance instruments (which are negative sum) and inherently positive sum instruments (like stocks). For example, the stock market is an inherently positive sum game because the value of US corporations is very likely to be positive sum in the long-run as firms accrue positive cash flows and grow endogenously. This is the real beauty of owning an index fund or any diversified portfolio. While individual stocks can have the attributes of a negative sum game (firms fail after all) a diversified index fund is a positive sum game in the long-run because you aren’t exposed to the single entity risk that can make stock picking a negative sum game at times. That’s because the index fund is consistently reallocating out of failing firms and replacing them with growing firms. You own something that is more akin to a perpetual entity than the typical firm which has a finite lifetime.

An insurance contract, on the other hand, is the negative sum in that there’s always a winner and a loser over a specific period. If you buy a term life insurance contract you’re either going to outlive the policy and earn a negative real return over time or you will die and you will earn a huge asymmetric positive return and the insurance company will earn a negative sum. But this doesn’t mean insurance is a bad thing. Insurance is great because, even though it could be a negative sum game, it gives you greater stability over time by hedging a potential risk. Interestingly, this is one of the main reasons why things like futures and options exist – because people want to insure against certain outcomes. For instance, in 17^th century Holland during the Tulip Bulb Mania, it was common for tulip growers to buy put options to protect their profits from potential downside. Likewise, wholesalers would buy call options to protect against the risk of tulip prices going up. These buyers were hedging their underlying exposure with an insurance-like option contract. Even though these contracts are negative sums, they serve a meaningful and real economic purpose. However, not all negative sum instruments serve an economic purpose.

I’ve watched the US capital markets evolve substantially in the last 25 years. When I was a young broker at Merrill Lynch the products I was most critical of were things like whole life insurance, variable annuities, and high-fee mutual funds or wrap products. While these products are often high fees and negative sums they still serve a real economic purpose. But today’s capital markets are increasingly turning into a strange amalgamation of casinos and capital markets. On the one hand, you have the entities that are the greatest investment vehicles in human history. US corporations are responsible for creating more wealth than any group of financial instruments ever. And on top of that, you have an increasing number of “securities” being issued that don’t really serve any economic purpose and simply leverage the performance of those underlying entities for gambling purposes. In many cases, these instruments serve zero economic purpose. Every day there are filings for single stock leveraged ETFs, cryptocurrency “memecoins” that serve no economic purpose, and other fanciful sounding “hedging” ETFs.

It’s funny in retrospect because you can’t really compare something like a memecoin to a whole life insurance contract. Although one is a high-fee insurance product it also has real economic utility while the other thing is literally just a zero-sum speculative instrument with zero economic utility. So, in many ways, these new instruments, despite having lower potential fees, are far worse. And so I guess I’ve done a bit of a 360 during the course of my career here where the things I used to criticize now look like good instruments compared to what is being issued these days.

And to be clear, I have no problem with people speculating on things. If you want to day trade stocks and be a perpetual liquidity provider to people who are using stocks to invest for the long run then that’s perfectly fine. You’re engaging in a negative sum game, but in the aggregate, you’re actually helping the broader positive sum game at work. I wouldn’t recommend you be the negative sum participant, but I also won’t tell you you can’t do that. But I find it especially odd that regulators are allowing this preponderance of new securities issuance that serve no real economic purpose. In my opinion, it sends the exact wrong message about the purpose of the financial markets relative to say, something like a casino or sports betting app. As that line increasingly blurs the probability for financial mishaps increases as people use their savings to engage in financial bets that don’t serve them well in the long run and mostly prey on people’s misunderstandings.

The causes of this are many. No doubt policy has had an impact and I’m sure many would agree that the Fed has specifically encouraged speculative behavior. We are also increasingly turning into what Keynes would have called a leisure society where people are bored and looking for ways to blow their disposable income. I’m sure it’s more complex than that and I don’t know the exact answer. If you do then shoot me a note.

My friend Jake, who goes by @econompic on Twitter says of this whole development: “A competent and trustworthy financial advisor is going to be more important than ever.” I’m biased for obvious reasons, but I wholeheartedly agree. It’s becoming increasingly difficult to differentiate between the things that are positive-sum investments and things that are dangerously speculative negative sum investments. So, be careful out there.

As always, stay disciplined!

More By This Author: