Luke Delorme: In stocks, it's all about the price

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GREAT BARRINGTON — On an average day in the world stock markets, more than $340 billion shuffles between buyers and sellers across more than 80 million trades. In a single company such as Apple, an average day consists of more than 26 million shares traded. This poses an interesting question. When a financial advisor, or an acquaintance at a party, tells you that they've got the next hot stock tip, what do they know that millions of market participants do not?

Answer: Nothing!

The notion that anyone can consistently predict the future direction of stock prices is hard to accept. The current price of any stock reflects the collective judgment of millions of traders and the risks involved with that company. Traders include analysts, advisors, hedge fund managers, retail investors, workers at the company, and countless others. Historical data for any company is publicly available and the expectations and risks for the company moving forward are known.

If a company has growth expectations, such as Amazon, it's in the price. It's no secret that Amazon is expected to displace retailers, so the price of the stock is bid up to reflect those expectations. The flip side is also true. Retailers such as JC Penney clearly have a lot of new competition from Amazon. This is reflected by a lower relative price.

Prices rise and fall based on what happens as compared with expectations. Amazon may have a bright future and displace hundreds of retailers and still not live up to expectations, and the price may fall. JC Penney may need to close half of its stores, but if the market thought they'd close all of the stores than the price of stock may go up.

Compare Tesla and Ford. Ford sells about 6 million vehicles a year, Tesla sells about 100,000. Most people agree that Tesla has limitless prospects for the future, whereas Ford's best days may be behind it. So, which company is worth more? According to markets, they have a similar value, with Ford worth about $46 billion and Tesla worth about $63 billion. It's clear that past data and future expectations are built into these values, and predicting which stock will go up or down from here is no more than guesswork. It's in the price.

(The theory that all data and expectations are built into prices is known as the "efficient markets hypothesis." It is a central hypothesis behind substantial academic work. It also underlies an increasing number of financial advisory practices and the trend toward "passive" investing.)

The implications of this hypothesis are instructive. First, if past data and future expectations are already in the price, it is a fool's errand to spend days on end researching and picking stocks in an effort to outguess the collective wisdom of the markets. Second, if a price rises or falls, it tells us something about future expectations. The market thinks the fortunes of a company, or a collection of companies, have become better or worse.

From this information—in the price alone—we can glean information about expectations. If everything is going well, prices rise because people are optimistic about the future and less worried about risk. Risk and return are entwined. When prices rise and perceived risk is lower, expected returns should be lower too.

On the other hand, when things are bad and prices fall, the market perceives an investment to be riskier. In order to invest, the expected return must be higher to take on the risk of a bad situation. When markets tumble as they did in 2008, everything was at its riskiest and expected returns were highest. Those investors willing to take on risk by owning stocks at that time have been rewarded.

The bottom line is that it's difficult to believe that anyone can consistently guess the future direction of stock prices. If Apple is planning to launch a new phone and you think that's going to drive the stock price up, it's too late. Everyone already knows about the new phone and it's built into today's price. To truly have a "hot stock tip," you'd have to have information that isn't known to the general public. That is insider trading, and it is illegal.

Although there may have been great stock pickers in previous generations, the information available at the click of a button makes the game far too competitive today. For investors, this should be a relief. They don't need to guess the direction of stock prices, they need only to determine how much risk they are willing to take.

Luke Delorme is the director of financial planning at American Investment Services in Great Barrington. He can be reached at luked@americaninvestment.com. Past performance is no guarantee of future results. This information should not be considered investment advice or a solicitation to buy or sell securities. A professional advisor should be consulted before implementing the options presented.


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