Celebrate the Price
By: Mary Brunson | Aug 23, 2011
Standard & Poor’s recent downgrade of U.S. debt has served as the impetus for enormous volatility throughout the global markets. Talk of troubles in Europe and even another recession in the U.S. have spooked the market and its investors—some of whom are now asking the time-honored question: Is it different this time?
Certainly, it is different this time, but isn’t the news always different? No two crises are the same. But, one critical function remains the same, and that is the market’s ability to price the news. This is no small task on the market’s part. This ongoing ability to absorb the news, collectively aggregate and reflect the opinions of all market participants and to arrive at a fair price for each security is an amazing fete which free markets accomplish spontaneously, elegantly and efficiently.
Reams of articles have hit the papers and the Internet to advise investors on what to do now. Most of which are supported by advertisements from firms whose profits increase with the volume of your trades. In an August 19, 2011 Wall Street Journal article titled “Last Straw or Time to Buy,” journalist Kelly Greene chronicles the advice that several financial advisors and money managers in the wake of the recent market turbulence. The article mostly discussed the misguided advisors who have either pulled back their expectations of future performance or are advising their clients to reduce allocations to equities.
Here’s why their advice is misguided:
- Prices are considered fair because they are determined by millions of willing buyers and willing sellers.
- Prices reflect the current and forecasted news.
Prices change so that (1) the expected return remains essentially the same, (2) there is an equal chance that the future return will be above or below the expected return and (3) the more the future return varies from the expected return, the less likely it is to occur.
A visual representation of this concept is found in the Hebner Model. To visualize how markets work, think of a teeter totter where the news (economic uncertainty) would be on the left side, the investment risk and expected return at the fulcrum, and the price on the right side.
The likelihood of identifying pricing mistakes and exploiting them for profit is a 50-50 proposition. And, don’t forget to account for the costs and taxes associated with trading. Will some gurus get lucky in calling the next market move? Of course, but luck is neither a reliable nor a repeatable skill.
Fear is on one side of the the trade and greed is on the other, both emotions being factored into the price. From here, the market has just as much chance of going up as it has of going down, and that is because of the magnificent pricing mechanism of the free markets.
So, the next time you hear an active investor utter those four most dangerous words: “It’s Different this Time”, remember the four most soothing words for passive investors, that news is already "Baked in the Cake.”
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