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.

Key Takeaways

  • 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.