How Markets Actually Work and Why it Matters

I’m a lucky guy.  Most people will  never get to have the view I do at work. I’m not talking about the actual view from my office.  I mean, Keystone Avenue is mostly covered by trees, which is nice, but otherwise it’s power lines, 86^th Street and the roof of the Fidelity Investments building (oh, the irony—if only the view included an Edward Jones office also, my life would be complete).  I can't complain—at least not until the leaves are off the trees and the sky turns to deep gray for half the year beginning in November.  Actually, I’ll try not to complain then either.  

The view I’m talking about is being able to watch markets working.  There is no single “stock market,” by the way.  The shares of a company’s stock trade in their own unique market.  Instead of imagining the NYSE, AMEX, NASDAQ, etc. as markets themselves, it’s more accurate to picture them as swap meets: a bunch of little booths, some busier than others,with lots of buying and selling. 
 
If you want to buy or sell a share of stock you have to go to its market and enter your order.  Now, you might feel that you would like to buy the stock, but only if it reaches, say, $10.  If that’s the case then you’d enter a “limit order” to buy at a price of $10 or less.  Or, if you own the stock already, you could enter a limit order to sell at $11.  In those cases, you would only buy (sell) your shares when the price traded down (up) to $10 ($11).  

Instead, you might simply want to buy the stock at the best price available right when you arrive at the booth, so to speak.  In that case, you would enter a “market order”. There are actually a bunch of other variations on these two types of orders, but those are the basics.

One way to describe a stock’s market is by talking about the “bid” and the “offer”.  The bid represents the best available price to anyone who wants to enter a market order to sell a stock, while the offer represents the same for the buy side.  You might also describe a stock’s market by way of its “volume”, or the number of its shares traded in a given day.    

In theory, the bid price reflects the probability that an informed buyer will trade with an uninformed seller. The opposite holds for the offer side. In other words, the bid and offer prices convey a lot of information about the market for a stock.  If there is a wide gap between the bid and the offer and if the volume is low, you can be certain that the informed traders on each side of this trade stand to make a bunch of money from the uninformed traders (e.g., individual investors).   

Let’s look at a real world example. Apple, Inc. (AAPL) is the largest stock in the world currently, with a market value of $635 billion.  Recently, Apple’s shares traded $677.51 (bid) x $677.58 (offer).  The seven cent difference is understandable: it just says that buyers and sellers disagree slightly on the fair value of the stock.  A seven cent “spread” on a price of $677.58 is about 1/100^th of one percent—sellers and buyers are disagreeing but only in the way that newlyweds disagree when they repeat “No, Pookie, I love YOU more!” to one another ad nauseum.
 
The market for shares of ALCO Stores, Inc. (ALCS) tells a very different story of what its buyers and sellers know about that stock’s fair value.  ALCS has a market value of $25 million—a tiny sliver of AAPL’s massive value.  These shares traded recently at $6.70 (bid) x $7.35 (offer); that's a spread of roughly 9% of the price.  If you were talking to a trader you could say that the spread is wide enough to drive a truck through. 

Why the difference in spread? Information.  Everybody knows about AAPL, and many of you own at least one of their products; news from the company hits the internet and is disseminated at the speed of light; there are literally scores of professional analysts dissecting every piece of available knowledge on AAPL and turning that information into opinions, which they share with buyers and sellers.

How about ALCS?  Oh, sure, you can find headlines on yahoo finance—not many, but you can see some recent press releases.  But have you ever shopped at ALCO Stores?  There may not be any analyst anywhere with a single informed opinion about the stock.  There is just no meaningful way to compare Apple’s information flow with ALCO stores. It’s basically two different worlds of information, and the massive bid–offer spread reflects this.  

What holds for stocks applies in other markets, too.  Take gasoline, for instance.  If you had the choice of Speedway gas for $3.70 or Shell gas for $3.90, you’d always stop at Speedway.  Why? Because you know that 87 octane unleaded gasoline is a commodity.  There may be external factors (my wife thinks Shell has very clean bathrooms, and one station might be on the wrong side of the street for the direction you’re traveling), but for the price of a commodity, you have all the information you need to purchase the cheaper alternative.  

If you're still with me, hang in there.  I'm building to the point. 

When you hear someone complain about the excesses of the “free market”, they mostly believe—incorrectly—that the problem is market freedom.  But, what they’re really objecting to is the scenario in which the Widow Bradford buys a share of ALCS for $7.35 only to find that she has to turn rightaround and sell it for $6.70, thereby losing $0.65.  Opponents of free markets see this possibility as unjust and consider it a type of market failure.

The knee-jerk reaction from these folks is to regulate away the possibility of injustice.  So, returning to our stock example, they might mandate that ALCS shares trade at certain prices.  But, who would determine what those prices should be?  Further, people might not want to buy those shares at all at the set prices, and the market would simply die.  They might also want to have the government support prices, through buying or selling shares to manage the market.  But here, too, government involvement creates price distortions that cloud risk and value discovery. 
 
Here’s the big idea: if you’re worried about the possibility of injustice from inefficient markets, you basically have two choices: you could regulate the markets or you could increase information flow, thereby increasing market efficiency.  The difference is that information aids in risk and value discovery whereas regulatory intervention creates distortions.  

The next time you hear someone propose that we “rein in” free markets, just ask them why we couldn’t accomplish the same end with more information instead?