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No Orphan Shares

No Orphan Shares

March 01, 2020

We are all swept up in the turmoil and uncertainty related to the health issues of Covid19 and its consequences for travel, entertainment, and investments. World-wide the capital markets have dropped significantly causing much concern. However, as usual, there is room for context and perspective which should have a calming effect.

When the media reports that everyone is selling, the statement is not correct. Every share of stock is always owned by somebody. There are no orphan shares of stock. The shares do not materialize or evaporate.

The more proper description is that some investors have decided that they no longer want to hold stocks. The decision to sell then joins their decision to do so as quickly as possible. Thus these investors are demanding immediate liquidity for a large number of stock shares. Such liquidity comes with a price in the form of a discount.

The result is an imbalance as the deluge of shares for sale hits the markets. Markets trade in an orderly fashion and prices move in response to changes in the balance of those wanting to sell and those wanting to buy. The price is the mechanism to keep all the factors in equilibrium.

Markets have trading “specialists” whose job is to ensure orderly trading, which means they stand ready to be the buyer or seller of last resort. With this specialist in the role of facilitating trades in place, buyers and sellers can be confident that they can complete their trade, but not necessarily at the price that makes them happy. They can seek the price they want, which may take time; or they can complete the trade quickly but at a price different than they might prefer. In other words, it is a trade-off.

Imagine yourself in the role of the specialist. You offer to buy at a certain price and to sell at a certain price. As buyers and sellers come to the market, they are matched with each other until there is an imbalance. Then the specialist steps in to facilitate the transaction.

Now suppose that you, as a specialist, look up and see a crowd rushing towards you wanting to sell. You can take your bids off the table and adjust the price as you wish. So can all your other colleagues working as traders in the same stock.

Your job is to enable sellers to complete their trade. Your job is not to provide a price that makes them happy. Since you are essentially buying for your own inventory, your objective is two-fold: to buy the necessary number of shares to satisfy the demand to sell; to buy at the best price for yourself. The question becomes how low a price you can offer. If some sellers decide not to sell at that price and withdraw their request, you have fulfilled your role.

To understand how trading markets work, you should look at three factors: price, quantity, and speed. These vary among each other and you must decide how to balance them. For example, if you place high priority on speed, then you must let quantity of shares and price fluctuate. If shares are the priority (say you want to sell 100,000 shares – a large amount) you must let price and speed vary. And finally to prioritize price, you must let speed and shares vary.

Within this framework, we now have a better understanding of the recent market decline. Many investors decided they wanted out quickly, their first priority. They wanted to sell all their shares, their second priority. Thus all the pressure was placed on price and it dropped to accommodate the other priorities.

We will see such turbulent trading activity until investors acknowledge that capital markets are intended to be long term investments. Trying to time them or outguess them is folly. To do so implies that they think they are smarter than everyone else in the world. Good luck with that!

Have a sound investment strategy. Stick with it. Do not let the “noise” of the moment distract you.

Be well financially and physically.