Thursday, July 30, 2009

The Cheshire Multiple

When a growing number of people buy stocks—and from one another, remember—prices are driven up because buyers outnumber sellers. And as brokerage statements indicate the last selling price of the stock, investor portfolios become inflated.

The economy can get into big trouble this way. You can’t buy the same stock back and forth numerous times, inflating its price, and think that you’re creating real dollars. Yet that’s just how many investors behave.

To illustrate, say that 10 million investors each own 100 shares of stock in a company. Then I pay $1 more than the last fellow for a share. As a result, the stock price goes up by $1, and all 10 million shareholders see their portfolios rise by $100. But did I create $1 billion of wealth, the total of that increase? Of course not.

This apparent $1 billion was generated by what I call the “Cheshire multiple” (after the disappearing cat in Lewis Carroll’s Alice’s Adventures in Wonderland). It exists mostly in the imagination.

Only a small percentage of investors can sell their shares at the price on their brokerage statements. As soon as sellers outnumber buyers, the price will fall and portfolios will shrink due to that same multiple. It works both ways. So most of this so-called money simply vanishes. No one gets it.

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