In last month's blog, "Jelly Beans and Investing Wisdom," we explained how group intelligence leads to relatively efficient markets. Now let's look at how prices are set moving forward. Understanding this will help us see how to work with the market rather than fighting it.
What causes market prices to change? The answer begins with the never-ending stream of good, bad and ugly news. For example, when there are reports that a fungicide is attacking Florida trees, orange juice futures may soar, as the market anticipates shrinking supply.
But what does this mean to you and your investment portfolio? Should you buy, sell or sit tight? The answer is that because of the way the market adjusts its pricing, there's not much you can do in reaction to breaking news to improve your investment outcomes.
There are two principles to bear in mind here. The first is that the news itself is not the most important factor; it's whether we saw the news coming. When a security's price changes, it's not because something good or bad has happened. It's due to whether the news was better or worse than expected.
If it had already been reported that the aforementioned orange-tree disease was expected to continue spreading, pricing changes might be minimal. After all, everyone was already expecting doom and gloom. On the other hand, if an ingenious new fungicidal treatment is released, prices might change dramatically in reaction to the unexpected resolution.
Thus, it's not just news, but unexpected news that alters future pricing. By definition, the unexpected is impossible to predict, as is the way the market will respond to it. Once again, group intelligence flummoxes those who might believe that they can consistently forecast future prices.
The second reason to consider breaking news irrelevant to your investing is what we'll call "The Barn Door Principle." By the time you hear the news, the market already has incorporated it into existing prices, well ahead of your ability to do anything about it. The proverbial horses have already galloped past your open trading door.
This is especially so in today's micro-second electronic trading world. In his article, "The Impact of News Events on Market Prices," CBS MoneyWatch columnist Larry Swedroe explored how fast global markets respond to breaking news. Pointing to evidence from a number of studies among several developed markets, he found that the universal response was nearly instantaneous price-setting during the first handful of post-announcement trades. In the U.S. markets, it was even faster than that.
In other words, unless you happen be among the very first to respond to breaking news (competing, mind you, against automated traders who often respond in fractions of milliseconds), you're setting yourself up to buy higher or sell lower than those who already have set new prices based on the news. And that, of course, is exactly the opposite of your goal.
It makes little sense, then, to play an expensive game based on ever-changing information and cutthroat competition over which you have no control. A better way to invest is by paying heed to a number of market factors that you can better expect to manage in your favor. We'll introduce these factors to you in a future blog.
But first, you may be wondering: Even if you aren't personally up to the challenge of competing against the market, perhaps there's a pinch-hitting expert out there who can do it for you. In our next blog, we'll explore whether that's the case.