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Understanding how ‘the markets’ work

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Thursday October 31, 2013 at 5:02pm
When people talk about ‘the market’ I often find myself wondering if they really know what ‘the market’ is and how it operates. The stock market is made up of literally millions of buyers and sellers who are buying and sell shares based on their judgment of the value of the shares they trade. A typical trading day on the US markets will consist of 39 million trades with a combined value of around $200 billion.

The market indices such as the FTSE 100 for example reflect the collective knowledge of all the buyers and sellers on that day. A good way to understand the power of this collective knowledge is to consider a jar full of chocolate buttons. If 50 people each guess the number of buttons in the jar there will be a range of answers. But the mean of all of the answers will be quite close to the actual number of buttons in the jar. In this way we know more together than we do alone.

So the market is about collective wisdom, to some extent.

By buying and selling shares each stock market investor is moving the price of each share traded, and their combined effort is reflected by the market price of that share. Although not the same this is not dissimilar to each person guessing the number of buttons in the jar and the mean of their answers being fairly close to the total number of buttons in the jar.

Like any market the price of each share and indeed the value of the whole market is determined by demand for shares (buyers) and supply of shares (sellers). However, demand and supply is itself influenced by available information relevant to the share being traded. But because information is freely available and instantaneously reflected in the price of each share it is very difficult, if not impossible, for one person to consistently outperform the market due to superior knowledge.

The real effect of trying to outguess all 39 million traders’ knowledge is for investors to take unnecessary risk by betting against the market and to significantly add to their anxiety levels. A better way to trade the market is to simply hold the market and harness the collective knowledge of all investors – take advantage of the collective wisdom, if you like.

Such ideas are not new, they were first proposed several decades ago by such academics as Eugene Fama who has just been awarded the Nobel Prize for Economics for his work on efficient markets. But they do make sense and it’s the investment philosophy we share with our clients when we look for low cost, effective investments that take advantage of the collective wisdom of the market rather than fighting against it.

Andy Parker
Chartered Financial Planner, Birmingham

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Parker Chartered Accountants and Financial Advisors is the trading name for Parker Business Development Ltd (Registered No. 4116664), Parker Tax and Trust Ltd (Registered No. 06950353) and Parker Financial Planning LLP (Registered No. OC347027). Parker Financial Planning LLP is authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales – registered office contact details here