Lemon

Lemon

A lemon is a very disappointing investment in which your expected return is not even close to being achieved, and more than likely ends up costing you some or all of the capital committed. For example, a car might be sold with mechanical issues that are so costly to repair, the price to fix the vehicle eclipses the sale price and value of the car. The most common and well-known example of a lemon is in the used car industry, where defective or poorly conditioned vehicles are bought and sold by the purchaser without prior knowledge of the true state of the vehicle. Regulations in the United States, for example, offer some protections to consumers in the event they purchase a defective vehicle, known as lemon laws. For example, many entities lost substantial sums of money in the wake of the 2008 U.S. financial crisis, after purchasing mortgage-backed securities derived from mortgages that were rated low risk when the risks were actually substantial.

A lemon is a purchase that turns out to be worth far less than believed, and may even end up costing the buyer more than the initial purchase price.

What Is a Lemon?

A lemon is a very disappointing investment in which your expected return is not even close to being achieved, and more than likely ends up costing you some or all of the capital committed. Lemon investments can be associated with poor money management, economic factors, financial fraud, or just plain bad luck.

A lemon is a purchase that turns out to be worth far less than believed, and may even end up costing the buyer more than the initial purchase price.
A used car with hidden flaws, or a property that has lurking mold, are classic examples of lemon purchases.
However, the concept can also apply to securities or other investments that turn out to be worth far less than they appeared to be.

Understanding Lemons

The most common and well-known example of a lemon is in the used car industry, where defective or poorly conditioned vehicles are bought and sold by the purchaser without prior knowledge of the true state of the vehicle. For example, a car might be sold with mechanical issues that are so costly to repair, the price to fix the vehicle eclipses the sale price and value of the car. Moreover, a vehicle might be sold with irreparable maintenance issues that will likely render it inert and unusable shortly after the purchase.

Comparable issues, in a figurative sense, can occur with other types of investments. Homes may have hidden damages and defects that can vacate the perceived market value. Infrastructure work, such as pipe replacement, foundation repairs, or extensive removal of mold, can escalate the costs of the residence beyond the means of the buyer, making it unlikely for them to affect the upgrades and fixes. That, in turn, can make it unlikely that the buyer will be able to resell the house at a price that would allow them to realize any value from the overall transaction.

Lemon laws exist to help protect consumers from manufacturers that might otherwise sell deficient or low-quality items.

Special Considerations

Consumers have some recourse in these instances. Regulations in the United States, for example, offer some protections to consumers in the event they purchase a defective vehicle, known as lemon laws. When a person buys or sells a lemon, they may be at a disadvantage if they do not have the same information necessary to make an informed decision as the other party to the transaction. This information asymmetry is sometimes called the lemons problem, a term coined in the 1970s by economist George Akerlof.

Lemon Investment Example

In investing, the lemons problem commonly arises in the areas of insurance and corporate finance, most notably in investment banking. For example, many entities lost substantial sums of money in the wake of the 2008 U.S. financial crisis, after purchasing mortgage-backed securities derived from mortgages that were rated low risk when the risks were actually substantial. In many cases, individuals working for investment banks possessed information indicating the risks were high, but the buyers of these banks' products lacked the same information.

Related terms:

Adverse Selection

Adverse selection refers to the tendency of high-risk individuals obtaining insurance or when one negotiating party has valuable information another lacks. read more

Expected Return

The expected return is the amount of profit or loss an investor can anticipate receiving on an investment over time. read more

Financial Crisis

A financial crisis is a situation where the value of assets drop rapidly and is often triggered by a panic or a run on banks. read more

Lemon Laws

Lemon laws are a form of consumer protection; they provide legal ways to address grievances when faulty products or services are sold. read more

Lemons Problem

The lemons problem is an issue of information asymmetry between the buyer and seller of an investment or product. The name comes from calling a defective used car a "lemon." read more

Money Management

Money management is the process of budgeting, saving, investing, spending, or otherwise overseeing the capital usage of an individual or group. read more

Non-Recourse Sale

A non-recourse sale is the sale of an asset in which the buyer assumes the risk of the asset being defective. read more

Short Sale (Real Estate)

In real estate, a short sale is when a homeowner in financial distress sells their property for less than the amount due on the mortgage. read more

Underwater

An underwater asset is worth less than its notional value, like a home worth less than its outstanding mortgage. Also referred to as "upside-down" or "out-of-the-money." read more