Financial Markets

Financial assets and the markets in which they trade play several crucial roles in developed economies. Financial assets allow us to make the most of the economy’s real assets.

Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects. When the market is more optimistic about the firm, its share price will rise. At that higher price, fewer shares must be issued to raise the funds necessary to finance a prospective project, for example, a research and development effort or an expansion of operations. And when fewer shares are issued, a smaller proportion of profits are absorbed by the new shareholders,leaving more for the existing shareholders and making the potential investment more attractive. The firm therefore is more inclined to pursue the opportunity. In this manner, stock prices play a major role in the allocation of capital in market economies, directing capital to the firms and applications with the greatest perceived potential.

Do capital markets actually channel resources to the most efficient use? At times, they appear to fail miserably. Companies or whole industries can be “hot” for a period of time (think about the dot-com bubble that peaked in 2000), attract a large flow of investor capital, and then fail after only a few years.

It is unreasonable to expect that markets will never make mistakes. The stock market encourages allocation of capital to those firms that appear at the time to have the best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on the stock market. Stock prices reflect their collective judgment.