When it comes to investing, things can get complicated very quickly. But it doesn't need to be that way. This is the first in a series of blog posts called "10 Steps to a Better Investment Experience" which offers ten ways to improve your experience with investing. This blog post is based on the BetterWealth Podcast, Episode 13 - Step #1: Understand Market Pricing.
STEP #1: UNDERSTAND MARKET PRICING
One of the best ways to understand market pricing is a take a closer look at how a pencil is made. In 1958, Leonard E. Reed published an essay about the combination of miracles needed to create a pencil. We can relate that to the work of Eugene Fama called the Efficient Market Hypothesis. Fama wrote that professional investors trying to beat the market through stock picking always had a poor record.
Why is that? Well, that’s where the pencil comes in.
A pencil is made up of four items: graphite, cedar wood, metal, and rubber. A pencil is inexpensive and it’s simple, but not one individual can make a pencil. The pencil is an end result of a very complicated market process.
There are millions of people involved with creating a pencil. All of them have their materials, their efforts, and their constraints. In order to cut a cedar tree you need a saw. To use a saw you need steel. To create steel you need iron. Iron needs to be mined. Transportation is needed for the iron. The list just goes on and on for the other materials used in making a pencil. It is a complex process that helps create the pencil and it is silly to think that any one person can make a pencil.
Each person involved with the creation of the pencil has their own costs. Each one of them is trying to maximize their profit. At the end of the day, all of the people in the process agree on a price for their services or materials, and that price is reflected in the pencil. The pencil is the result of a dynamic process of buyers trying to get inexpensive goods while sellers are trying to maximize their profit. No one person participating in the pencil market is smarter than anyone else, because the pencil cannot be made by just one person. In essence, the market is smarter than the individual. There is actually a short video based on the essay by Leonard E. Reed that you can find here (I, Pencil: The Movie).
In the stock market, there are millions of participants buying and selling every day. In 2015, it was recorded that there were nearly 100 million trades on a daily basis. Stock prices are just a reflection of all of the information available in a market.
So what does that mean? The market is self-correcting. A pencil in essence is just a small glimpse of what happens in the stock market every day. Millions of participants buy and sell securities in the world markets, and the real-time information they bring helps set prices.
Trying to find little mispriced nuggets to take advantage of just doesn’t work in reality. You can’t compete with a collective knowledge, with millions of people also knowing about that information. You can’t be smarter than every other market participant. The Efficient Market Hypothesis says that the average investor cannot profit from attempts to beat the market through stock picking - it's a fools game.
Instead of trying to fight the market, you should embrace and understand market pricing. You should try to find a strategy that harnesses the collective power and information of the market.
In our next blog article, we are going to talk about Step 2 to a Better Investment Experience: "Don't Try to Outguess the Market." But first we needed to understand market pricing and how the story of making a pencil provides a glimpse into the incredible complex tapestry of markets and how prices are formed. The story makes clear that no single person possess enough ability or know-how to make a pencil.
*In US dollars. Source: World Federation of Exchanges members, affiliates, correspondents and non-members. Trade data from the global electronic order book. Daily averages were computed using year-to-date totals as of December 31, 2016, divided by 250 as an approximate number of annual trading days.