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Say you're at an art auction. Everyone around you is dressed to the nines. As you walk, you notice the crowds gather to only a few paintings on the walls. Buzz ensues. These, it seems, are the popular pieces. Whispers filter through the room as want turns into need.
Not long after, a side door opens to a wide room filled with decorative wooden chairs with leather seats. The crowd rushes in, eager to find a place up front. Hushed tones reveal longings. ("I must have the Pollack!" "That Seurat piece is gorgeous!")
Finally, the buzz becomes a roar as the auction begins. Unloved pieces are ignored, but then the Pollack reaches the stage. The auctioneer announces a minimum bid, but it doesn't matter. Five minutes of shouting later, a winner emerges. He's beaming -- not because he won the bid at a fair price, but because he knows it's the piece everyone else wanted.
This, Fool, is too often what a market order looks like, especially when you're chasing a hot stock.
Think of Apple (Nasdaq: AAPL ) , which has soared on huge volume thanks to enthusiasm over the forthcoming iPhone 5. Or perhaps salesforce.com (NYSE: CRM ) , which has benefited not only from CEO Marc Benioff's gift for salesmanship but also its positioning as poster child for the cloud computing movement. I think it's fair to say some have bought on the promise of the cloud without knowing what that promise is or what it entails.
Woodshed, meet Mr. Market Order
What if we banned market orders? What if you had to name a price before you bought a single share of anything? That same party might look very different.
Some might be dressed to the nines, sure. Others wouldn't be. Everyone, regardless of dress, would check in at the door and get a catalog with a list of items. No values would be attached. Instead, auction attendees would be asked to write sealed bids for the items they wished to purchase. The best bid would win -- no shouting, no whispers, and no chaos. Just an orderly assembly of people who like art and know the price they want to pay.
This, Fool, is what a limit order looks like.
By now you know where I'm headed with this. Limit orders are preferable for long-term investors. Market orders? Not so much. But before I go further on this topic, let's talk briefly about how these orders work practically:
- A market order instructs a broker to purchase or sell a certain number of securities as fast as possible, at the best available price at that moment.
- A limit order specifies a price at which the broker is to buy or sell a certain number of securities. These types of orders can be kept alive till they're cancelled or expire the day they're entered. Investors can also specify whether the entire order is to be filled at once or a little at a time.
Market orders are generally cheaper; limit orders trade cost for a greater amount of control.
The parable of the collector
I'll admit that arguing for limit orders sounds preachy. Why should I care if you're willing to pay whatever it takes to buy my shares of Apple? Don't I profit from your greed?
Yes, I do. But if the function of a market is to orderly price stocks with the long-term goal of achieving fair value -- legendary investor Ben Graham's "weighing machine," as it were -- then it's very important that market participants (i.e., investors) say something about price. Otherwise, volume and momentum take over and the data no longer fairly represents anything other than popularity.
To be fair, every market has hiccups. Take collectibles. Beanie Babies were so hot at one time that a single plush doll could command hundreds of dollars. Demand was a function of volume, and volume determined price, just as it sometimes does with the market's hottest stocks.
Look at Groupon (Nasdaq: GRPN ) , which is up more than 12% on huge volume as I write -- largely because of reports of a new mobile-payments system -- yet few in our Motley Fool CAPS database believe the underlying business value justifies higher prices. The stock rates just one of five possible stars.
Why we need limit orders now more than ever
Therein lies the problem: Volume says little about value. Yet in a lot of cases, volume accounts for most of what we know about hundreds of tickers. Markets are moving at previously unheard-of speeds.
U.S exchanges handled 41,836 "quotes" -- pitches to buy and sell at a certain price -- every trading second in last year's fourth quarter. All signs suggest that quote volume will rise in the months and years ahead.
Think about that. With so much happening so fast, the delta between what common investors hope to pay when they issue a market order and what they end up paying could be huge. Just ask those who bet on Facebook (NYSE: FB ) at the IPO and lost. Or ask the Knight Capital (NYSE: KCG ) traders who failed to correct a glitch before hundreds of errant trades were executed faster than the blink of an eye.
The Foolish takeaway
Ready to shut down your brokerage account and squirrel away your retirement savings under your bed? Don't. As dangerous as markets -- and market orders -- have become for traders, the changes shouldn't matter much to long-term investors who take the time to determine fair value.
This isn't true just for stocks. Maintaining a price discipline matters in nearly everything we do as consumers. Whether it's buying stocks or buying food or clothing, figuring a fair price allows for maximizing precious resources.
And isn't that what investing should be about? Please weigh in using the comments space below.