When Markets Fail
The stock market isn't meant to be a casino. Its primary purpose is to help high-quality businesses raise capital at a reasonable cost to develop and provide innovative services and products. In an efficient stock market, sound businesses and talented entrepreneurs attract capital and thrive. Companies that are ill-conceived and/or mismanaged do not attract capital at a viable cost and are eliminated.
However, in a bubble market, shady firms and incompetent or dishonest entrepreneurs can also raise ample amounts of capital on favorable terms. In the recent A-shares bubble, stories abound where retail investors paid 400 times earnings for firms with no actual assets or sales. This creates a perverse incentive to business owners. Why work so hard to build a long-term enterprise? It is much easier to sell a pie-in-the-sky dream to investors and profit from their optimism and trust by unloading personal shares at ridiculously high prices. An irrational stock market could actually convert talented business operators into scheming stock price manipulators looking for quick personal profits.2
In a very inefficient stock market dominated by retail trading, taking advantage of credulous investors becomes a powerful profit engine for owners of listed firms and traders at hedge funds and other financial institutions. This turns the stock market mostly into a wealth transfer mechanism with little positive benefit to the real economy.
Should Naïve Investors Be Disqualified?
Retail investors achieve better investment results buying professionally managed funds than speculating in individual stocks (Barber and Odean, 2013). There is also evidence that the overall quality of the market improves when the ratio of professional investors to retail investors rises. Akbas et al. (2015) show that, in aggregate, mutual fund flows exacerbate cross-sectional mispricing, presumably because mutual funds disproportionately purchase stocks that are already overvalued. Hedge fund flows, however, act as arbitrage capital that corrects cross-sectional mispricing. Their findings suggest that increasing the share of institutional investment would tend to make markets more efficient. There are indeed grounds for arguing that retail trading should be curbed.
Of course, prohibiting retail investors from directly speculating in the stock market is not feasible. However, governments might improve the professional-to-retail investor ratio by encouraging more institutional participation. In the case of China, that means affording pension funds greater participation in the equity market and raising the Qualified Foreign Institutional Investor quota.
It has long been an unstated fear in Asian countries—notably China—that savvy foreign investors trading for short-term profits would wreak havoc on the domestic equity market. For example, an external high frequency trader could trigger a flash crash in the Chinese stock market. The more likely outcome, however, is that global pension funds would provide long-term institutional capital to the Chinese market on the basis of disciplined valuations. The benefits are potentially enormous: A more efficient stock market would nourish good companies and reduce the profitability from fleecing retail investors.