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How the stock market should work

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A report by economist John Kay has shown how the UK stock market should be changed to work in everybody's interests. 

by Gavin Lumsden on Jul 27, 2012 at 08:57

How the stock market should work

I look at an important report by Professor John Kay of the London School of Economics into the UK stock market.

Kay explains how the 'equity investment chain' linking savers, companies and the City should be reformed for the long-term benefit of the country.

You can see the other videos in this series on The Lolly Investor Programme page.

Hello and welcome to the Lolly Investor Programme,

I’ve come to the London Stock Exchange to talk about how stock markets should work for all of us.

In theory the stock market is a wonderful money-making machine.

Companies list on the stock exchange to raise money from investors who buy their shares. If all goes well and if the businesses are well managed, the shares rise in price and pay a growing level of dividend, which investors can either reinvest and make their money grow even faster or take the dividend as income when  they retire.

The problem is the reality often falls well short of the theory.

An endless cycle of stock market bubbles and crashes and scandals over City pay makes it seem that investment bankers are the only ones making the money while ordinary savers get left with bad investments.

In fact the problem is wider than that.

Last week, when I talked about investment bonds I explained how they had been widely sold to the public because they paid advisers more commission than other financial products.

Some financial advisers were pumping products on their customers because it suited them, rather than because it was in their customers’ best interest.

And this kind of thing goes on all the time.

Fortunately, this may change.

This week has seen the publication of a really important report by John Kay, a professor at the London School of Economics.
Kay was asked by the government to look at how the UK stock market operates and how it helps or hinders long-term planning in this country.

His report provides a brilliant analysis of what has gone wrong with financial services in the past 50 years.
Kay describes how as the stock market has grown in complexity what he calls an ‘equity investment chain’ has developed.

Equity is another word for shares so what he is describing is the chain of connections between savers and companies.
Nowadays relatively few people own shares directly in companies. Instead, they invest in some kind of fund, which invests in lots of different companies.

This means companies are not that bothered about individual shareholders. It’s more efficient for them to focus on the fund managers, who represent the public, and a host of City analysts and bankers who represent other big, institutional investors.

The problem is that as the investment chain has stretched, and more and more parties have got involved, ordinary investors have become disengaged from the companies in which they invest.

Also the whole chain has become far too busy, busy, busy.

Kay is damning on how the equity chain has become dominated by a hyperactive culture of trading and selling and chasing short-term profits rather than a more steady process of managing, advising and planning.

In other words the spivs have triumphed over the professionals.

The most important insight from Kay’s report is that the system isn’t working for anybody. No one trusts anyone. People aren’t saving, the City is held in contempt and companies aren’t raising money from the stock market anymore.

Kay’s solution is a system of stewardship in which each party in the investment chain takes their responsibility to the next party seriously and does what they think is best for the long-term creation of wealth.

So, directors would strive to manage their companies according to sensible, strategic, business plans.
Fund managers would back those companies and not sell their shares as long as they stick to those plans.

Investors will not expect fund managers to deliver top of the table returns every quarter but will settle for good long-term returns instead.

It’s powerful stuff. I really hope the recommendations in the Kay report are backed by the government. If they are, we could have an historic chance to turn theory of a share owning democracy into practice.

2 comments so far. Why not have your say?

dakky via mobile

Jul 27, 2012 at 12:51

What does Professor Kay say about short selling which seemingly allows 'professionals' in the City to sell shares they don't own. I guess he doesn't recommend the man in the street is allowed to borrow shares then sell them high before buying low!

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Jul 27, 2012 at 14:03

There was a time when the stock market worked in most peoples interests, including PI's and companies That has of course all changed. And is presumably the reason for his input.

But those working within it now, would certainly not welcome any change back to those values.

However as many have seen recently, the public and political perception of bankers ( a generic term to cover investment- hedge funds and all) has caught up with that change, and now stands at an all time low. As sub prime , PPI mis- selling and Libor mix with Pay, Pay off's and the Bonus culture.

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