What Makes Financial Markets Work?
410 days…That’s all it took to create one of the seven wonders of the modern world. Over 3,000 masons, architects, steelworkers, and skilled laborers worked together on the Empire State Building. For nearly forty years it stood as the tallest building on earth, an undeniable example of efficiency, produced through the collective use of knowledge. It’s a simple concept that can be applied to just about any industry and it underpins the basic idea of why markets work.
The functionality of financial markets, like any market, is based on open and ongoing participation in an environment where decisions are made based on an opinion of value. Market efficiency isn’t a new idea. The concept of exchange for equal or greater value is enshrined in our DNA. For every buyer, there must be a seller and vice versa. In order to execute a trade, each side has to at least initially feel like they’re getting a good deal. So, what makes markets efficient?
Decision Making: Groups Vs. Individuals
At any given moment, a single person acting independently is capable of making an uninformed decision. Individuals are at a distinct disadvantage in the decision-making process because they often draw conclusions from their own limited set of data. Groups on the other hand, while still capable of exhibiting poor judgment, are less likely to make mistakes due to the benefits of collective brain power. You’ve probably heard the old adage a thousand times “two heads are better than one.”
Financial markets operate on the same premise, acting at the will of millions of participants who make judgments through the active buying and selling of companies based upon massive quantities of information. In a sense, they’re voting with their dollars. The act of buying or selling effectively moves stock prices in one direction or another until it reaches an equilibrium. Therefore, the current price that a stock trades at should represent a good estimate of what that company is worth because it captures the sentiments of millions of buyers and sellers.
The Judgment of the Masses is Hard to Beat.
Markets don’t trade on yesterday’s information, or even today’s. Alternately, they look toward the future, and trade based on the collective masses interpretation of tomorrow’s value. So, if two heads are better than one, millions of heads are most assuredly better than two. This is the main reason why stock mispricings are so hard to identify. A speculator would have to believe that they know something that everyone else doesn’t already know about a company because the current stock price is a reflection of all voting participants, i.e buyers, and sellers. In a world where news travels at the speed of light, what are the chances of that? Even if they did know something, and for argument’s sake let’s say a speculator was in possession of information that wasn’t already reflected in prices. What are the chances they can act on this information fast enough to benefit from any price change? In a 24-hour news cycle, it’s hard to keep much of anything a secret. As word spreads, the value of information is depleted by the second.
With instant access to breaking news in the palm of our hand, information has never been so readily available as it is today. Collectively, the way we interpret information empowers us to freely evaluate the value of things, including companies we choose to invest in. In most every instance investors should operate under the assumption that prices are fair and accurate. Markets work because they are a global reflection of what we think works.
By Tim Baker, CFP®
Advice and investment design should rely on long term, proven evidence. This column is dedicated to helping investors across the country, from all walks of life to understand the benefits of disciplined investing and the importance of planning.