For most products, there are things you can do to resolve the information gap -- if you don’t trust a used car salesman about the quality of a car, you can have it checked out by a mechanic. In most markets, reputation is also important.
In finance, however, these tools have often proven to be less reliable than for cars, houses or other products. Taking complicated credit products to a “mechanic” didn’t work in the run-up to the 2008 financial crisis -- the more opaque the product, the more willing the credit rating agencies were to sign off on it. As for reputations, these often simply added to the crisis -- people were probably too willing to enter into contracts with risky banks like Lehman Brothers and Bear Stearns, precisely because of these companies’ sterling reputations.First - the comparison with the mechanic would make more sense if you took the car you were about to buy to the mechanic that works for the dealer. Banks hire rating agencies to sign off on products as part of the marketing for that product. For many institutional buyers, any investment without an investment grade rating isn't going to even get a sniff. There is an inherent conflict of interest here. The bank needs a highly rated product, and the rating agency needs clients. While the products that were sold with supposedly AAA credit turned out to be extremely risky, I doubt the rating agencies fully understood the product and should have said as much. If you take a Tesla to a diesel mechanic, you would hope the diesel mechanic would tell you that he can't help you rather than tell you that everything looks fine.
Noah continues:
Why is asymmetric information so crucial to an understanding of financial markets? It’s probably related to the reason people want financial assets in the first place. People want cars and bananas and microwave ovens because those things are immediately useful. But most people who buy and sell financial assets have no intrinsic desire for the asset itself -- they only care about how its value to other people will change in the future. That means that while information is important for many products, when it comes to financial markets, information is the product....I may be misreading this, but Noah seems to think of financial markets as a sort of hot potato where everybody makes money except the person left with the potato when the music stops. If I sell an asset, it is because I believe that asset will no longer continue going up. I'm holding that potato as long as possible, with the hopes of dumping it off to somebody else right before the last note. And if I am the one with the most information, I have the best guess as to when that music is going to stop. So why should anybody buy anything in the financial markets if the game is to make every buyer the bigger fool? The only things for sale would be things I wouldn't want to buy.
...Suppose you come to me offering to sell me a stock for $100 a share. Why are you offering to sell it to me for $100? Maybe you’re selling stocks because you’re shifting into bonds, or ready to retire, or need to pay a sudden medical expense. But chances are, you think the stock is worth less than $100, and you’re trying to unload it. That should make me wary about taking you up on your offer. But on the other hand, if I jump at the offer, that should tell you that I have reason to believe the stock is worth more than $100 … and that should make you wary.
Of course, markets don't work that way. The volume in stock and bond markets far exceed what you would expect if most trades are just to offload a soon-to-be dead asset. So why are these markets so active? If markets are efficient and react quickly on all publicly available knowledge, once any material information is released, prices will reflect that new information. Suppose you have a stock that was worth $10 yesterday, but something happened today makes you think it is now worth $5. You might decide to sell it, but how much can you get? If you are the only person that has this bit of new information, maybe $10. If the information is public, then much less. Someone might think that new piece of information is not as awful as you do, and maybe offers you $6. Happy to get rid of something at what you now see as a 20% premium, you make the trade.
Did anybody get screwed in this transaction? If the seller made the trade based on non-public information, then the buyer probably did. That is the purpose of insider trading laws. If market participants aren't comfortable making trades out of fear that counter parties have material non-public information, the market will dry up. But if both parties have the same information, but that information leads to different assessments of an asset's value, transactions can occur. The same principles apply in business acquisitions. Wanda's Farm Supply might be doing just fine today. But Wanda might think the future is a little bleak so she takes bids to buy out her business. Maybe Rupert's Feed Store has been looking at opening a farm supply store and decides that buying Wanda's shop would provide a much higher return on his investment than starting from scratch. Rupert pores over Wanda's financial statements, customer lists, etc, and decides the business is a good buy. Rupert pays Wanda what he thinks is a fair price, Wanda is happy to get paid on what she thinks is a declining business, both parties are happy. The stock market is the same - people are buying and selling businesses based on current profits and projected growth.
Unfortunately, the stock market has become Wall Street's version of Caesar's Palace as speculators throw money at things they don't understand. If I want to buy a car but don't understand how a car works, I should find my own mechanic to take a look at it - and a mechanic that understands the type of car I want to buy. If I want to buy a stock but don't understand balance sheets or income statements, I should find my own financial professional to take a look at it that has expertise in the type of stock I want to buy. If I play the market like a slot machine, I should expect the house to win.
Noah says that asymmetrical information "is at the core of finance. It's key to the way traders, including high-frequency traders, make their profits." If asymmetrical information was so key, I would expect more traders to have higher risk-adjusted returns than their respective benchmarks. The fact is, they don't. The reason is that, for all the information that traders might hoard, they are still guessing on what will happen in the future, just like everybody else. While they might have some very smart guesses that turn out to be profitable, they also might wildly miss on others. Noah says traders are more informed because they "know something about the asset's fundamental value," but unless they have (illegal) insider knowledge, they have the same set of information that others have. The more information, and the more complex that information is, the wider variation in "fundamental value" among traders.
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