How the stock market is like a used car dealership
Lambert here: Even I know what a lemon market is!
Given the many factors driving shares up or down on any day or week, it’s hard to make sense of what’s happening on Wall Street
Based on my many years of experience teaching and writing about financial markets and frauds, I believe the best way to understand what’s happening on Wall Street – and puncture its mystique – is to imagine it as a used car dealership.
Stock markets 101
Stock exchanges are places where people trade ownership in corporations by buying and selling shares.
Partial ownership of a company comes with benefits, such as a cut of future profits and rising stock prices. But there are risks and costs as well. Share price can fall, reducing the value of one’s wealth; even worse, businesses can go under, reducing the value of ownership to zero
The New York Stock Exchange, one of several in the U.S., is the largest securities exchange in the world. At a current market value of almost US$23 trillion, it’s worth more than the GDP of the U.S. and the world’s other big economies
Stock exchanges play an important economic role by helping companies finance new investments. When a large company wants to expand, it goes to an exchange like the NYSE and offers investors a stake in its business through what is known as an initial public offering. That’s exactly what ride-hailing services Lyft and Uber plan to do at some point in 2019.
Selling Used Cars
However, this is not what stock trading is mainly about. Virtually all the $80 trillion or so in daily trading on the NYSE and other exchanges around the world involves someone who already owns shares of a company selling them to somebody else. In other words, it is very much like a used car dealership.
Used car dealers buy old automobiles and resell them. Similarly, stock markets are places where someone sells their ownership in a company to a dealer, who then finds someone else to buy it.
That is it. Ownership of a company changes hands, with the exchange serving as the middleman
These exchanges have benefits. They enable us
But there are also negatives to stock markets
As used car buyers know, it is easy to end up with a lemon. Most people don’t know the specifics of a particular used car. Its past and even its present condition is often a total mystery.
And car dealers have incentives to hide flaws in what they’re selling – and thus deceive potential buyers. Revealing flaws in the car will likely lose them sales and commissions.
Similarly, investors typically don’t know much about a particular company. Such knowledge requires doing a lot of homework about the company – its past history, its senior executives and its future plans – as well as knowing how to read financial statements. This is much harder than homework on a specific car that you are thinking about buying
And just as car dealers can make a lemon look good for a test drive, companies can cook their books or drive up their stock price to make themselves look good
Furthermore, the stock market can help turn companies into lemons. Wall Street’s focus on short-term stock price gains means that it cares more about what will generate a quick buck rather than what will support long-term growth and profitability. Consequently, companies end up focusing more on doing whatever drives up the value of its shares at the expense of producing quality products efficiently, worker training and customer satisfaction
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