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The Principle of Two-Sided Transactions in Competitive Financial Markets

written by: John Garger•edited by: Michele McDonough•updated: 6/13/2010

The Principle of Self-Interest suggests that people act in their own financial self-interest. Yet it must not be forgotten that other people are working in their own self-interest as well. Learn how the principle of two-sided transactions can help you make better investments.

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    Two-Sided Transactions

    In theory, the Principle of Two-Sided Transactions seems quite simple; certainly investors understand that for every seller there is a buyer. However, when transactions are not conducted face-to-face, it is easy to forget about parties on the other side of table. The Principle of Two-Sided Transactions helps to remind investors to avoid self-centeredness when making financial decisions.

    Buying & Selling

    Suppose that a company has ceased to be as profitable as it had been in the past and, consequently, the stock price of the firm has fallen. Typically, holders of the stock will sell so as to avoid any more bad outcomes in the future should the stock price drop further. This may seem like a good idea but remember that for every seller there is a buyer.

    Clearly, buyers of the stock have more optimistic views about the company’s profitability than the sellers. Essentially, the buyers believe that it is a bad idea to sell the stock and therefore take advantage of the “bad" decision of the sellers to dispose of a security that will have more value in future than it has now. Of course, sellers think it is a good idea to sell. This is a simple example outlining the Principle of Two-Sided Transactions.

    Winners & Losers

    Financial transactions can be viewed as zero-sum games. One player of a game wins only because another player loses. Higher prices benefit the seller and lower prices benefit the buyer. However, not all financial transactions are zero-sum games because there are many extenuating circumstances that affect the two sides of a transaction differently.

    Taxes, current holdings, decision-making ability, etc. affect investors in different way. As such, the Principle of Two-Sided Transactions is not a simple accounting of one side winning because the other side lost. Taking into account how a transaction will affect the other party can help set prices and conditions that make certain each party is acting in its own self-interest.

    Understanding the Other Side of the Transaction

    Too often, investors believe they know more about the value of a security they really do. This egotism leads to overvaluing a security regardless of how the rest of the market has set the price. The egotistical investor believes that he/she knows more than the entire market which is made up of millions of investors. This results in bad decision-making and unnecessary loses due to contempt for other investors’ ability to properly value a security. Knowing that other investors are acting in their own self-interest is the beginning to understanding how powerful the Principle of Two-Sided Transaction is in financial decision-making.

The Competitive Financial Environment

The competitive financial environment is governed by four distinct principles. These principles encompass the idea that attaining value is a matter of competition resulting in winners and losers. The principles outlined here are an overview of this competitive environment.
  1. The Principle of Self-Interested Behavior in Competitive Financial Markets
  2. The Principle of Two-Sided Transactions in Competitive Financial Markets
  3. Signaling in Competitive Financial Environments
  4. How Investors Use the Behavioral Principle in Competitive Financial Markets