Adverse selection in stock markets refers to a situation where one party, between the seller and buyer, has more information about a particular company than the other. Adverse selection creates inequality when it comes to a stock market trade.
For example, the seller of stock has information about how the quarterly results of the company before it is announced, and the buyer doesn’t. The seller will get the advantage here. Here, the company could have poor results, but the buyer doesn’t know that. The seller takes advantage as they sell the share below it probably goes down after bad news while the buyer is kept blind.
Adverse selection makes the marketplace an unequal place. Adverse selection hurts the market in the long term. Hence, authorities ensure the same is avoided at all costs. For instance, authorities like SEBI and SEC require all companies to disclose comprehensive information in a timely manner that reaches all the shareholders. The shareholder letter you may receive every now and then is a part of this disclosure.
For example, let us imagine that a company is changing its CEO. The news should ideally reach all the shareholders with equal importance and speed so that no one takes advantage of the lack of information of any party. A management change could have a huge impact on a company, and it will be reflected in the share price as well. If only one party has information, it will lead to adverse selection giving the buyer or seller an unfair advantage.
Adverse selection is more prevalent in the case of insurance policies. Adverse selection insurance happens when a person is given an insurance policy underestimating the risk associated with the person. For instance, if a person works in a high-risk environment and the person is given insurance without considering the same because of a lack of knowledge, it results in adverse selection in insurance.
What is an Adverse Selection?
Adverse selection is a phenomenon that happens when there is an asymmetry in information between buyers and sellers. Adverse selection leads to one party getting an unfair advantage. Adverse selection may lead to market failure.
Let us understand adverse selection with a simple real-life example.
Let us imagine that you are trying to sell a second-hand item in a marketplace. Only you know about the condition of the item and what all it has gone through. If you decide not to reveal critical information regarding the condition of the item, you are creating an adverse selection. The principle of the market fails here, and you will be given an unfair advantage.
Similarly, adverse selection in stock markets happens when the buyer or seller has more information about the share that the other party doesn’t have access to. Different stock markets ensure this is prevented using strict rules regarding information disbursal to the shareholders.
Adverse selection is most prevalent in the field of insurance. For instance, in the case of health insurance, the applicant chooses not to reveal certain medical conditions they have created an information inequality.
How does Adverse Selection work?
Adverse selection happens when a buyer or seller in trade has more information than the other party. Information inequality could happen due to two main reasons – unavailability of information resources and deliberate attempts at the adverse selection.
The former happens when a buyer or seller is kept blind from a piece of information about a trade due to a lack of resources available to them. In the case of stock markets, the buyer or seller may not have access to the agency or news outlet that puts out the information. Stock markets try to avoid adverse selection by mandating different forms of information outlets for important news.
The second is when the seller or buyer has information that the other party has no access to. Information disparity happens when a seller or buyer has access to internal information. This action amounts to insider trading, and it is illegal.
What are Adverse Selection examples?
Let us examine three hypothetical examples of adverse selection.
Adverse selection happens in the stock markets if one party has information that the other party doesn’t have. The adverse selection gives one party more advantage over the other. Adverse selection happens in many forms. One example is when a buyer sells stocks, knowing that they will decrease in value. The knowledge here doesn’t come from research or expertise but because they know a piece of information that the other party doesn’t.
Adverse selection also happens in the case of insurance policies. Let us imagine that a person is taking a health insurance policy without revealing their complete health information. Understand that health insurance policy premiums are priced according to the current health condition of the buyer as well. When such information is kept a secret, the buyer gets an unfair advantage. At the same time, the risk of claim increase for the health insurance company without their knowledge.
Adverse selection happens in physical marketplaces as well. Let us imagine that person A is a fruit seller and B a buyer. B is buying fruit from A, thinking the fruit is fresh. But A has altered the fruit, which is weeks old, and doesn’t reveal the information to B. B becomes the victim of adverse selection here as A gets an unfair advantage.
How does Adverse Selection affect economics?
Adverse selection negatively affects economics too. Economics is built upon balance and equality. An economy works best when the buyer and the seller are treated equally. But when adverse selection happens, the balance of the economy gets disrupted. Adverse selection may even cause markets to fail. That is why governments take strict action against adverse selection.
Is Lemon Problems and Adverse Selection the same?
Adverse selection is the asymmetry in the information available to buyers and sellers. The lemon problem is a type of adverse selection. The lemon problem happens when there is a degradation of the quality of products available to the buyers in the market due to asymmetry in information distribution. The lemon problem happens because sellers normally know more about the products than the buyers. For instance, if you are a TV manufacturer, you will know more about the defects of the product than the buyer. But you will never advertise the same as it will cause lesser sales.
Is Advantageous Selection the same as Adverse Selection?
Advantageous selection and adverse selection are two economic conditions that happen due to information asymmetry. Risk-averse individuals tend to insure themselves with an amount more than nominal in the case of advantageous selection. The advantageous selection also creates market inequality. At the same time, adverse selection is when one party has more information than the other, thereby getting an unfair advantage.
What is the difference between Adverse Selection and Moral Hazard?
A moral hazard is a type of adverse selection that affects the economy. A moral hazard is when a party enters an agreement without good faith. They may be hiding relevant information or lying about something. The main difference between a moral hazard and an adverse selection is that the information hidden in the former may not be illegal but falls more into the scope of morality.
