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What is the purpose of financial markets? How does a financial market (such as a market for stocks and bonds) work?
Financial markets are markets specifically designed for moving and managing money. This includes stock and bond markets as well as insurance markets. What other markets do for tangible goods, financial markets do for capital—essentially, they direct it to where it can be the most productive, which, in general, is where it’s earning the highest return.
In this article, we’ll explore the economics of financial markets, explain the four basic needs they serve and discuss the common misbelief about financial markets, which is that you can “get rich quick” using them.
Financial Markets Serve Four Needs
To get to grips with the economics of financial markets, your first need to understand four basic needs that people have in an economy:
- They allow people to raise money.
- They allow people to store, protect, and profit from excess money.
- They insure people against risk.
- They allow people to speculate.
1. Raising Money
The most basic use of financial markets is to allow us to raise capital, either by borrowing money or by selling stocks. In either case, financial markets allow us to raise money for things we couldn’t afford otherwise—for a price, of course. Financial markets allow us to:
- Borrow money for consumption: People use credit cards to borrow money against their future earnings in order to consume something now but pay for it later: for example, to purchase a new television.
- Borrow money for investment: People use banks or venture capitalists to borrow money to invest in something—generally something that will make them better off down the road, such as equipment for a business expansion.
- Raise capital by selling assets: People use the stock or bond markets to raise capital without borrowing, by selling investments in the form of stocks or bonds.
2. Storing, Protecting, and Profiting From Excess Money
Financial markets allow us to store our excess money so we don’t have to use it as soon as we earn it. While we may take this for granted, consider that throughout most of human history, people couldn’t do this with their precious resources: They’d have to eat their harvest or their hunted animals soon after they’d acquired them, or they’d lose them to rot.
Financial markets also help us store our money safely, protecting it from theft. It’s harder for a robber to steal your money from a bank or from the stock market than from a shoebox under your bed.
Additionally, financial markets protect us from another, more subtle, thief: inflation. If you store your money in a shoebox, it will lose value over time, while if you invest it, it will (usually) keep up with inflation, or even grow faster than it.
Financial markets also give us opportunities to put our excess money to use and make it profitable, by connecting us with people who are looking to borrow money. This is essentially what we do when we, for example, buy stocks: We allow a firm to borrow our money to invest it in their business, on the assumption that we can profit off of it later.
3. Insuring Against Risk
Life, and business, is full of risks. Financial markets can help protect individuals and firms from the effects of bad luck, using:
- Insurance policies: People purchase insurance to protect things like their jewelry, cars, houses, health, and lives. The idea is that a large number of people pay a predictable, relatively low amount to an insurance company, which promises to pay a large amount to any of those people who suffer a significant loss.
- Futures contracts: These are trades that lock in a future price for a commodity, allowing, for example, a farmer to contract to sell her corn next year at $4 a bushel. If prices go lower than that, the farmer still gets the $4 she contracted for. If prices rise to $10 a bushel, she still only gets the $4 she contracted for. She trades her potential for a future windfall to protect against a future loss. Because commodities are vulnerable to significant price swings, people who trade in them often take advantage of futures contracts.
- Catastrophe bonds: These are insurance policies for insurance companies, protecting them against a catastrophic event that might bankrupt them, such as an especially violent hurricane season.
- Credit default swaps: Though these investments were abused in the lead-up to the 2008 financial crisis, their basic concept is innocuous. They’re simply an insurance policy for lenders, so that a bank that finances mortgages to risky borrowers can be insured against those borrowers defaulting on their loans.
4. Speculation
Financial markets also enable another basic human instinct: the urge to speculate—to bet on price movements. You can bet against future prices for just about anything: commodities, corporate earnings, federal interest rates, and so on.
Speculation can, at times, lead to system-wide problems, which is what happened with the aforementioned credit default swaps in the 2000s. Credit default swaps can be used not only to hedge against risk in your own transaction, but also to bet on another person’s transaction. For example, you can bet on someone else’s chances of defaulting on their mortgage. When this gets out of control, so that thousands of these “bets” are riding on certain transactions, the effects of those transactions are multiplied. Thus, when people started defaulting on their poorly-structured mortgages in 2007, their losses were amplified throughout the market.
Because the stock market allows for speculation, some people think of it as an investor’s version of Las Vegas. However, there are far more differences between those two markets than there are similarities:
- In Las Vegas, gambling is a zero-sum game—if you win, the house loses, and vice versa. In the stock market, transactions are a positive-sum game: Wealth begets more wealth.
- The odds are heavily stacked against Las Vegas gamblers, while in the stock market, you can reasonably expect to make a decent living if you play by certain rules and don’t follow bad bets. Remember that the point of financial markets is to allow you to invest your money, allowing others to use it productively, for a return. Despite the risks inherent in the system, overall, it is designed to make people money.
- Las Vegas transactions are purely for entertainment, while stock market transactions create a lot of societal good: Wall Street builds companies, manages risk, and allows individuals to comfortably retire.
Why You Can’t Get Rich Quick
Financial markets such as the stock market have a reputation for allowing people to “get rich quick” by betting big on a stock that pays unexpectedly large returns. Unfortunately, this reputation is misleading. Although it certainly can happen occasionally—just as gambling in Las Vegas can occasionally make a person wealthy—the unremarkable truth is that get-rich-quick schemes usually fail because they hit two realities:
1. All Information Is Public
First, it’s unlikely that you know more than other investors about any particular stock. If you’re looking to bet on a stock that will increase in value significantly more than other stocks, you’re essentially looking for an undervalued stock that no one else has noticed—in a world filled with people constantly looking for these kinds of things. Not only are you competing with investors with decades of experience and training, but you’re also competing with supercomputers programmed to seek out pricing imbalances. The chance of you outsmarting them all is small.
The main reason you can’t outsmart other investors is that all information you can make trading decisions with is available to the public. In order to outsmart other investors, you’d have to have access to information about a company that other people don’t, such as yet-unrevealed test results for a new medicine. However, it’s illegal to trade on information that’s not available to the public, so even if you had access to such knowledge, you’d be unable to act on it.
Large, sudden price movements are driven by unanticipated occurrences, such as a company unexpectedly announcing that it missed its sales targets, or suddenly becoming the target of a criminal investigation. The paradox is that these events drive stock price changes because they’re unpredictable, which means—importantly—you can’t predict them any better than anyone else can.
2. People Don’t Typically Undervalue Their Own Stocks
Second, get-rich-quick schemes violate a fundamental principle of economics: that everyone, not just you, is looking to maximize their utility. In the same way that you want the stocks you hold to have a high value, other people also want the stocks they hold to have a high value. People don’t make money by underestimating the value of their stocks; if the stock is strong, they’ll price it accordingly. Therefore, if a company has a good chance of succeeding in its industry, its stock will typically reflect that, and you are unlikely to discover a stock priced low that is actually worth a lot.
Again, everyone in the market has access to the same data. Therefore, in general, stocks are priced to accurately reflect all the available information pertaining to them, and it isn’t possible to maintain long-term success by buying and selling undervalued and unnoticed stocks.
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