How Does Market Pricing Work? | AWM Insights #114
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Episode Summary
When markets are down, it is natural to be concerned. Who determines these big moves in the market and what information can we learn from them?
Every transaction in the public market needs a buyer and seller. The transaction they make is reported and publicly available to access.
The market these buyers and sellers compete in is an extremely competitive and highly efficient marketplace. New information is incorporated into prices virtually instantaneously. Current prices reflect the collective knowledge and wisdom of an entire globe of educated and intelligent people competing relentlessly against each other.
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Episode Highlights
(0:15) Markets are volatile right now and can be unnerving. How should you go about investing in times like this? Is there anything I should be doing?
(1:18) How is market pricing determined and what assumptions can I take from these prices?
(2:15) Public market prices are easy to look up and are quoted daily in the news. The S&P, Dow, and NASDAQ are the most commonly referenced.
(2:50) The benefits of public markets with their liquidity and accessibility are also detrimental when markets become volatile. It is hard to ignore the headlines even for informed long-term investors.
(3:29) Market pricing is determined by a buyer and a seller. Millions of stock market transactions are completed every day.
(4:18) Markets are not perfectly efficient but markets are extremely competitive these sellers and buyers are setting prices.
(4:48) In 2021, there was $775 billion dollars worth of trades.
(5:24) War is going on and inflation has been impacting markets and reacting to new information virtually instantaneously.
(6:00) Efficient markets don’t mean prices are correct, it actually means the current price is the best estimate of the collective wisdom of market participants.
(7:20) An example is valuing Apple’s stock. There are 100s of analysts whose sole job is to accurately estimate the price of the stock. The numbers show even someone fully dedicated to figuring it out is usually wrong.
(8:30) Market information in public markets is regulated and insider trading is illegal. People are put in jail pretty often for using this competitive advantage to gain an edge.
(8:50) Investors as a group are very good at estimating using collective knowledge to pool all guesses together and the average ends up very close. Individually, the estimates are not close.
(9:30) Guessing the number of jelly beans in the jar is a classic example of the wisdom of crowds to find the right number.
(11:03) The model of using the power of markets and the wisdom of crowds to determine price leads to a better investing experience.
(11:30) Focusing on what you can control and listening to the evidence affords you the ability to spend your time and energy on areas where you can create value and impact.
(12:25) Next week will be on resisting chasing past performance. One of the most difficult things to do as an investor.
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+ Read the Transcript
Brandon Averill (00:06): Well, Justin, we're back. Another exciting episode here. At least the markets are pretty exciting right now. We're seeing a lot of volatility going on. Definitely getting some questions, which is extremely natural. If you don't have a reaction to what's going on right now, either you're a really high qualified advisor, or you've got ice in your veins. So, we thought we would do a little series here, and really take the opportunity to kick off, more as a way to reassure clients, so hopefully our clients are listening to this, and then also just to frame for our audience. Times like these, they're unnerving, but what is the best way to go about investments? Investing your portfolio, the hard earned money that you've earned? How do you actually put that to work in a really smart way?
Brandon Averill (00:57): It's testing, right? You're going to see markets go up and down, and in times where they go down, you naturally should question, am I doing the right things? We thought it'd be good to revisit some of the basics, and we're going to kick that off today. We're going to talk most importantly, or I guess where we're going to start, is with market pricing. Sounds like a fancy term, but really, what assumptions are we basing our decision making upon? And can we trust those assumptions?
Brandon Averill (01:26): I think a lot of times, especially the financial media, is going to throw a lot of things out there and make us question it, but I thought it would be really good, Justin, maybe for you to just start there, and let's talk a little bit about how prices are even established in markets. How do we know if they're right, or maybe they're not? Maybe they're wrong, and there is some way to game the market. Maybe start there, talk a little bit about markets, and how they price, and what kind of information we can glean from it.
Justin Dyer (01:56): This is a real meaty topic. We'll try and keep it as entertaining and engaging as possible, because it can be very academic, can be a little bit nerdy or geeky, if you will. But it's really, really important at the same time. What we're talking about a lot here is public market prices as well. We'll try and do our best to frame or qualify whether or not we're talking public market, private market. For the most part, we're going to be talking about public market prices here, because that's really what is front and center. When you turn on the news, or go online and look at whatever news source it is, you'll see the S&P 500 experienced another day of volatility, another down day, another update, whatever it may be.
Justin Dyer (02:41): To your point, there has been a lot of volatility, both up and down. That's one of the benefits of the public markets, how liquid they are and accessible they are. But in times like this, it's also a real detriment or a negative aspect of it, because it is so front and center. It really does get your emotions going, and like you said, it's only natural to kind of ask questions or pause and think.
Justin Dyer (03:09): So, we're going to, like you said, go through this series and talk about the fundamental beliefs that we have about around pursuing a better, or implementing a better investment experience. A lot of it does start with the fundamental aspect of markets, how markets work. What do you need to establish pricing, market pricing, and quite simply you need a buyer and a seller, and think about the real estate market.
Justin Dyer (03:32): That's a very, very simple way, or going, even to the grocery store, that's a market, there's a buyer and a seller there that come together to make a transaction. Stock market is really no different, there's a lot more volume. However, within the stock market than there is at the grocery store, or even within the real estate market, for everyone real estate property, maybe there's five, 10 buyers or potential buyers, obviously only one actually gets there.
Justin Dyer (04:00): Within the public stock market, there are millions of transactions and buyers and sellers that come together on a daily basis, and really at the end of the day, that is what leads to what we've talked about time, time, and time, again, a much more efficient market. Is it perfectly efficient for anyone who's really steeped in this topic? We're, going to keep it high level, we don't want to get too into the weeds, but is it perfectly efficient? No, by no means, but it is a really highly competitive, efficient marketplace where buyers and sellers are coming together to exchange stocks for, or bonds for actual cash, and they're doing so based on real time information and their substantial amount of information that comes into every single one of these trades that happen on a daily basis.
Brandon Averill (04:54): Yeah. No, and I think that's a great point, and, and by a lot of trades, right?
Justin Dyer (04:57): 775 Billion worth of trades last year, so what happens, like you said, when you have a buyer and a seller, and there's a trade, is it gives us all a lot more information about what's actually going on, so while all of what we've been experiencing lately may be unnerving, it's actually a sign of a really healthy market. We've had some pretty negative events happen in the world. We've had wars going on, inflation numbers are ticking up, there's interest rates are going up, to say the least.
Justin Dyer (05:32): So what's happening, is the market, the market participants are taking this information in and re-establishing a price for, let's say for a security based on the new information that's being provided, and when we see markets move like this and react to information, it's actually a good thing. It starts to validate.
Brandon Averill (05:51): Most definitely.
Justin Dyer (05:52): And so, I think that's the other thing, and you hit on this, that the next natural question should be then, efficient markets. I think a lot of people get confused on this, but does that mean that the price for everything is correct? And, the short answer is no. That's pretty impossible, but what it is saying, is that, or at least what you're having to believe, or what you should believe it, that it is the best estimate of what the value actually is, because if we unpack that a little bit, if you believe that's not the best estimate, then you have to believe the other side of it. That their market is actually wrong, and that the price is not what the collective wisdom is saying that it is.
Brandon Averill (06:39): So you're taking the stance that your beliefs, your thought on what a stock or the stock market, et cetera, is actually being priced, is more educated or better than the collective 775 billion worth of trades that went through.
Brandon Averill (06:54): Right. Am I, am I spot on there?
Justin Dyer (06:56): No, you're spot on. Another way to even frame that, and actually, a Portfolio Manager early in my career made this statement, and he was actually with an actively managed firm, no less, oversaw billions upon billions of dollars, he basically said, "You know, you think about it like this. Let's take Apple as a perfect example. Everyone knows that company. There are probably a hundred analysts that cover that stock, and each one of those analysts spend essentially every minute of their waking day of their professional life, trying to come up with what the accurate price of Apple should be.
Justin Dyer (07:34): Well, first of all, they actually don't do a very good job of that. The numbers show you, we can get into that. That's a whole nother podcast, but then just take a step back, even from that data. Divorce yourself from that for a second. Ask yourself the question, "These people are spending every waking minute on one single company, why do we feel like we have any sort of additional insight in what Apple should be worth, versus those individuals?"
Justin Dyer (08:01): Again, still, within those individuals, they don't do a very good job and they're spending every minute of their waking day. Why do we have any additional insight into that and what Apple should be worth, and the short answer is you don't. The numbers show that. You could get lucky, but there's no skill in that. There's a big difference between skill versus luck in that equation and something to keep in mind.
Brandon Averill (08:22): Oh I think it's a great point, and I think going back, the reason why this is so hard to do is because, in the public markets, information's regulated. If you have information other people don't have, sure, you have a competitive advantage. Don't trade on it, because you'll likely end up in jail, and they have pretty good ways of finding people like that, but at the end of the day, if you have the same amount of information, then you're probably going to arrive at a pretty good number, and as a collective, we are horrible. This human nature species, right? Horrible at estimating things on our own.
Brandon Averill (08:58): We all know that if count how many calories, there's all kinds of studies, right? You're in a diet, count the number of calories, you're missing by 30%, but if you take maybe a hundred people, you start to, you probably start to get a lot closer. I think there's a great example.
Brandon Averill (09:15): There was an advisor, that's been quoted time and time again, that tells a story about setting a jar full of jelly beans on the table at a client event, and put out a contest, so we want you to guess how many jelly beans are in the jar. We've probably all played this game when we were kids at some point, right? But, it was pretty fascinating what ended up coming out of that jellybean example. Everybody had access to the same information. Everybody could see the jar. Everybody could pick it up, everybody could turn it over and hold it and all that type of stuff. If you had been the one putting the beans in the jar, competitive advantage, but everybody else, you got to look at this jar, and there was an incredible range of guesses.
Brandon Averill (09:56): Somebody guessed 400 on the low end, 409, somebody on the high end, 5,365, and we're talking a hundred people guessing on this jar at least. The average guess was 1,653. The actual number of jellybeans in the jar was 1,670. We are just better together.
Justin Dyer (10:18): Right.
Brandon Averill (10:18): Right?
Justin Dyer (10:19): And let me just jump in too, and you can call this the wisdom of the crowds, and even I want to go back to your point about the price being only right or not, doesn't really apply to that jelly bean example perfectly, but the other way to think about this and you alluded to it, is that these are models, right? This is the best model that is out there to explain reality. I think that's a really important piece to keep in mind.
Justin Dyer (10:48): Is it perfect? No, but it's a lot better than the other models in terms of explanatory powers of what happens on a day to day or annual, week to week, annual, year over year, whatever you want to call it movement within the markets. It explains the most, and it gives you a higher confidence in your outcomes and leads you, we've mentioned to a better overall investment experience over the long term. I think that's a really, really important point to hit on. Brandon Averill (11:15): No, I think it's a fantastic point, and so we're going to wrap things up today, but the key takeaway we really want you to take away from today's episode, and we're going to hit on this theme also to end the rest of these episodes, is really starting to control what you actually can control. You can't control some crazy hypothesis on whether the market's up and down, or a company should be worth something else.
Brandon Averill (11:42): Really take yourself back to the evidence. Control what you can control. Control the fact that the market provides a lot of information, and is going to give you the best possible price that we all could probably figure out, so use that information and start that as the starting building block for pursuing this better investment experience. And in doing so, you're going to build your financial structure better, we're going to get into how you control taxes, all those types of things, but this is really a foundational building block we want you to focus on.
Brandon Averill (12:19): Next week, we're going to kind of continue this series. The next building block we're going to jump into is Resisting, Chasing Past Performance. This is another fantastic one, and I'm sure going to blow a lot of people's minds that unfortunately the winners don't keep winning here in the public markets like they do in the private markets, just to continue to draw that distinction, but before we close out again, reminding everybody, we'd love to get a text from you. Hopefully this episode was helpful. We'd love clarifying questions, or even questions about chasing past performance that we'll hit on next week.
Brandon Averill (12:56): That number to shoot me a text is 602-704-5574. Would be happy to respond to you directly, and then also address it on the podcast.
Brandon Averill (13:07): And until next time. Own your wealth, make an impact, and always be a pro.