In our last piece, we described, Our Marvelous Markets and how to account for it being both robust and random at the same time. Today, we’ll look at how stock pricing works, and why Nobel laureate William F. Sharpe was correct when he reminded us: “Asset prices are not determined by someone from Mars” (even if it may sometimes feel that arbitrary).
- Markets are inspired by ingenuity, tempered by diversification.
- The price you pay matters.
- Patience is a virtue.
- Investing is personal.
- Bring it all together. The financial plan.
Random Numbers, Efficiently Arranged
Why was Berkshire Hathaway Inc.’s Class A stock (BRK-A) priced at more than $400,000 per share as of mid-September 2022? Why do other stocks trade for pennies on the dollar? Why did Meta’s (META) share price dropped by more than 50% last year, while Consol Energy Inc.’s (CEIX) more than doubled?
As we touched on in our last post, we caution against trying to predict a stock’s future price based on the information at hand. But it helps to know those data points are not drawn out of thin air. Both moods and mechanics factor into each price set every instant the markets are open for business. As a result, like markets in general, stock pricing can be both remarkably efficient in aggregate, as well as wildly unpredictable from one moment to the next.
Stock Prices and Power to the People
Behind all the number crunching and academic theory that goes into predicting a stock’s next price, many of the seemingly random mood swings have to do with whatever we, the people, collectively believe a stock is worth. Bids pour in from sources ranging from high-paid analysts and institutional managers to hotshot day-traders and everyday investors. Combine them all, and the price is ultimately whatever actual buyers and sellers settle on when they trade.
Here’s how Sharpe has described market price-setting:
“Simply put, when you think about securities markets, remember that the prices of securities are set by human beings trying to assess the range of future prospects for companies, governments, and other issuers. In a sense, the price of a security reflects the average opinion of investors about its future.”
Credited with establishing the capital asset pricing model, Sharpe is worth heeding. So is his fellow Nobel laureate Eugene F. Fama, who further explains why group-think pricing represents the best overall estimate of a stock’s worth in relatively efficient markets (where market prices reflect all available, relevant information and all information is incorporated into prices):
“[T]here are large numbers of rational profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.… In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.”
An Investment’s Intrinsic Value
Circling back to the practical matter of making money as an investor, if we assume:
- Stock shares ultimately represent an ownership stake in a real company, delivering measurable goods or services.
- The price at which shares can be bought or sold is continuously set and re-set by what market players collectively agree the shares are worth at any point in time, based on the company’s underlying metrics, as well as capricious investor sentiment.
- As long as a company keeps exceeding investor expectations, its stock price can keep climbing (although growth on growth often becomes increasingly difficult to sustain).
Does this mean stock prices are irrelevant? Should we be willing to pay any price for any promising investment?
Not so fast. Consider this warning from Sharpe, often overlooked by professional and individual traders alike during times of heady price-setting excitement:
“[I]n any given period … you could get higher return, you could get really higher return, you could also get your head handed to you. And a lot of people forgot that.”
In other words, academic insights and public information help us understand why Berkshire Hathaway’s Class A shares have been able to exceed an astounding $500,000/share in stronger markets, without ever having imploded (yet). Markets are relatively efficient at setting roughly accurate prices based on a constant trade flow. As a result, stock markets have flourished over time and around the world, as have countless investors who have participated in their aggregate growth over the long term.
But these same insights also explain why real-time trading prices can swing wildly up and down around a target price. Which is why, as Berkshire Hathaway Chairman Warren Buffett has observed about buying stakes in a company: “What is smart at one price is stupid at another.”
Assuming the Price Is Right
Bottom line, the stock price you pay does matter, just not in the way many investors may think. By understanding how price-setting works, we can stop trying to game the system while it’s still in play. We focus instead on investing broadly, diversifying widely, and sticking around, as expected growth in overall stock prices translates into expected returns over time.
This brings us to our third investment fundamental, which we’ll cover next: Patience is a virtue. Please be in touch if we can answer any questions before then.
Disclosure: The opinions expressed herein are those of SYM Financial Corporation (“SYM”) and are subject to change without notice. This material is not financial advice or an offer to sell any product. SYM reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This blog is for informational purposes only and does not constitute investment, legal or tax advice and should not be used as a substitute for the advice of a professional legal or tax advisor. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. These companies have been selected to help illustrate the investment process described herein. This information should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the holdings listed have been or will be profitable, or that investment recommendations or decisions we make in the future will be profitable. SYM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about SYM including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request.