In our last piece, we described our marvelous markets, and how to account for their being both robust and random at the same time. Today, we will 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).
Why is 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 has Meta’s (META) share price dropped by more than half year to date, while Consol Energy Inc.’s (CEIX) has more than doubled?
As we touched on in our last post, we caution against trying to predict a stock’s next price based on the numbers at hand. But it helps to know those numbers 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.
Behind all the number crunching and academic theory that goes into discovering 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 is how Sharpe has described market price-setting (emphasis ours):
“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 (emphasis ours):
“(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.”
Circling back to the practical matter of making money as an investor, if we assume:
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 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.
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.”
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 is 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 now brings us to our fourth investment basic, which we will cover next: Patience is a virtue.
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This post was prepared and first distributed by Wendy J. Cook.