Why market prices are right

Why market prices are right

Why are market prices right, and why is trying to outguess them so often a losing game? Every day we happily pay the market price for all sorts of goods and services, yet many of us view the financial markets quite differently. We assume shares must be either undervalued or overvalued, and we try to be clever, buying before prices rise and selling just before they fall. Accepting the price is the first step in the Six Steps to Successful Investing series, and it's built on some of the most consistent evidence in finance.

In this video, you'll learn why academic research has repeatedly shown that markets are actually very efficient. It comes down to what statisticians call the wisdom of the crowd. Imagine asking two people to guess the number of sweets in a jar; they'd probably come up with very different numbers. But ask two hundred people and take the average, and it's likely to be remarkably close to the true figure. The same principle applies to markets: with millions of trades made every hour, each one represents the very latest collective estimate of what an asset is really worth.

You'll also learn why trying to time those movements is so difficult. Prices do change constantly, but it's unexpected news that drives them up and down, and by definition the unexpected can't be predicted. What's more, markets absorb new information in milliseconds. By the time you've read and processed a piece of news yourself, it's almost certainly too late, because that information is already reflected in the price.

The takeaway: rather than trying to spot mispriced shares or outsmart millions of other investors, the wiser course is to accept that the market price already reflects the best available collective judgement. Accepting the price is the first step to successful investing, and it frees you to focus on the things that genuinely make a difference to your long-term returns.

Chapters / Key points

• Why we accept market prices everywhere except the financial markets
• Why we assume shares must be undervalued or overvalued
• What the academic evidence says about market efficiency
• The "wisdom of the crowd" explained with the sweets-in-a-jar example
• Why millions of trades reflect the latest estimate of value
• Why unexpected news, which can't be predicted, moves prices
• Why markets react in milliseconds, leaving you too late
• Why accepting the price is the first step to successful investing

Transcript

Accept the price

Every day we happily pay the market price for all sorts of goods and services. But many of us see the financial markets differently. We assume, for example, that shares are either undervalued or overvalued. We try to be clever and buy before prices rise and sell as they're about to fall.

But academic research has consistently shown that markets are actually very efficient. It's all down to what statisticians call the wisdom of the crowd.

Imagine you invited two people to estimate the number of sweets in a jar. They'd probably come up with two very different numbers. But if you asked, say, two hundred people to guess, then took the average number, it's likely to be pretty close to the correct answer.

Now apply that to the markets. There are millions of trades made every hour, and each one represents the very latest estimate of the entire market as to how much an asset is worth.

Of course, prices change all the time. But it's unexpected news that causes them to rise and fall. And, by definition, the unexpected is impossible to predict.

Also, markets react to new information in milliseconds. So by the time you've processed the news yourself, it's probably too late. The new information is already reflected in the price.

So the first step to successful investing is to accept the price.