Understanding How Markets Work for You: Principle 4 in Evidence-Based Investing

How market work - happy middle aged couple

The financial markets have rewarded long-term investors. Understanding how markets work is a worthwhile investment of time and resources. People expect a positive return on the capital they supply, and historically, the equity and bond markets have provided growth of wealth that has more than offset inflation.

News, Inglorious News

So, what causes market prices to change? It begins with the never-ending stream of news about the good, bad, and ugly events forever taking place. For example, when there are reports that a fungicide is attacking Florida trees, orange juice futures may soar, as the market predicts there’s going to be less supply than demand.

But what does this mean to you and your investment portfolio? Should you buy, sell, or hold tight? It pays to understand how markets work. Before the news tempts you to jump into or flee from breaking trends, it’s critical to be aware of the evidence that tells us the most important thing of all: You cannot expect to consistently improve your outcomes by reacting to breaking news.

Great Expectations

How markets work - Person reading a newspaper
how Photographer: Roman Kraft | Source: Unsplash

How the market adjusts its pricing is why there’s not much you can do in reaction to breaking news. There are two principles to bear in mind here.

First, it’s not the news itself; it’s whether we saw it coming. When a security’s price changes, it’s not whether something good or bad has happened. It’s whether the next piece of good or bad news is better or worse than expected. If it’s reported that the aforementioned orange tree disease is continuing to spread, pricing changes may be minimal; everyone was already expecting doom and gloom. Then again, if an ingenious new fungicidal treatment is released, prices may surge 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 how dramatically (or not) the market will respond to it. Once again, group intelligence gets in the way of those who might still believe they can outwit others by consistently forecasting future prices.

How Markets Work: The Barn Door Principle

how markets work - barn door
Photographer: Thomas Debay | Source: Unsplash

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 a 2013 article, “The impact of news events on market prices,” financial author Larry Swedroe explored how fast global markets respond to breaking news. Pointing to evidence from a number of studies, 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. And if anything, technology has become even faster since then.

Graph Stock prices adjust quickly
In USD Source Bloomberg. The security identified is shown for illustrative purposes only to demonstrate the investment philosophy described herein. These materials are not, and should not be construed as, a recommendation to purchase or sell the sell security identified or any other securities. Actual holdings will vary for each client, and there is no guarantee that any client will hold the security identified.

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. That’s exactly the opposite of your goal.

Your Take-Home

Don’t try to play an expensive game based on ever-changing information and cut-throat competition over which you have no control. Instead, continue to learn how markets work. That way, you can position your life savings according to market factors you can better expect to manage in your favor. We’ll start covering these next.

To see all 10 principles of Evidence-Based Investing at a glance, please visit our Evidence-Based Principles Guide. These principles inform our investing process.

About the Author Douglas Finley, MS, CPWA, CFP, AEP, CDFA

Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.

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