Investments, tenth edition

   The Informational Role of Financial Markets 

 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. That higher price makes it easier for the firm to raise capital and therefore encour-

ages investment. In this manner, stock prices play a major role in the allocation of capi-

tal 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 capi-

tal, and then fail after only a few years. The process seems highly wasteful. 

 But we need to be careful about our standard of efficiency. No one knows with certainty 

which ventures will succeed and which will fail. It is therefore 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. 

 You may well be skeptical about resource allocation through markets. But if you are, 

then take a moment to think about the alternatives. Would a central planner make fewer 

mistakes? Would you prefer that Congress make these decisions? To paraphrase Winston 

Churchill’s comment about democracy, markets may be the worst way to allocate capital 

except for all the others that have been tried.