031 – What Determines a Stock Price?
What determines a stock price. Let’s use an analogy to illustrate What determines a stock price. Have you noticed how car buying has changed? In the old days, you pulled up to a car dealership at a significant disadvantage, because you had no idea what the car was worth. There was a sticker price on the vehicle, and you knew that was probably not a fair price to pay. But it was all the information you had. So you bought the car and left the dealership wondering if you paid a fair price. Maybe you even tried to haggle, or do the dance with the dealer. But more often than not, you felt like you were being taken advantage of—because you most likely were. The salesperson had more information than you, and therefore, they had the upper hand.
But now, you can go online to several websites and figure out exactly what that car is worth. You can know ahead of time what you should pay for the car you want. If you do the research, you can walk out of the car dealership knowing you paid a fair price. The balance of power has changed. You have just as much information as the car salesperson now. The experience at the car dealership is efficient for you, because you have all the available information about that car’s cost.
The stock market is not any different than the car buying experience. There was a time when stockbrokers had information on companies and could find ones that were mispriced and buy them for you—and it might have given you an advantage. But those days are gone, because now, with the advent of computers just 50 years ago and programs that track every single detail about a company and make those details available to the general public, all information about all companies is available to the millions of stock market participants every day. There is no longer an advantage trying to pick winning or mispriced stocks because the stock market is now efficient, just like car buying.
Professor Eugene F. Fama performed extensive research on stock price patterns. In 1966, he developed the efficient markets hypothesis, which asserts that current securities prices reflect all available information and expectations.
This framework has several implications for investors. If current market prices offer the best available estimate of real value, stock mispricing cannot be systematically exploited through securities selection or market timing. Moreover, only unanticipated future events will trigger price changes, which is one reason for the apparent short-term “randomness” of returns.
It is called the efficient market hypothesis. The hypothesis states four things, and it doesn’t state 4 things.
The Hypothesis States:
Current prices incorporate all available information and expectations.
Current prices are the best approximation of intrinsic value. Here’s a simple example of a market at work. It shows how collective knowledge can come together and be stronger than the knowledge of any one person.
At a client event hosted by a financial advisor, a jar of jelly beans was placed in the lobby and attendees were asked to estimate the number of jellybeans it contained. The participants wrote down their estimates, and whoever offered the closest estimate to the actual count received a prize. There was a broad range of estimates—409 to 5,365 jelly beans. The average of all estimates was 1,653. The real number was 1,670. This experiment has been repeated at other client events, and the average of all guesses is usually very close to the actual count. The principle is that the combined intelligence of a group is better than the knowledge of one person. Together, we know more than we do alone.
Current prices are the best approximation of current value.
So, consider how this aggregation of knowledge and opinions works in the financial markets. Millions of participants buy and sell securities around the world. In the US markets alone, investors trade billions of dollars in stocks and bonds each day. The new information buyers and sellers bring to the markets help set prices—and with each bit of new data, prices adjust accordingly. No one knows what the next bit of new information will be, as the future is uncertain. But we can accept current prices as fair. This doesn’t mean that a price is always right because there’s no way to prove that. But investors can accept the market price as the best estimate.
If you don’t believe that market prices are good estimates—if you believe that the market has it wrong, you are pitting your knowledge or hunches against the combined knowledge of thousands or millions of other market participants.
Price changes are due to unforeseen events.
When new information comes out about businesses, security prices change. This is information that no one new previously. When this new information comes out the information changes very quickly.
“Mispricings” can occur but not in predictable patterns that can lead to consistent outperformance.
There may be mispricing in the stock market but there is not a reliable method to create outperformance, given the high cost of trading.
The Hypothesis Does not State:
1. All investors are rational. 2. Prices are always right. 3. Prices should be stable. 4. Professional money managers can’t earn higher than market returns.
Conventional managers attempt to identify mispriced securities or predict the future direction of the market. These efforts may result in frequent trading, higher turnover, and concentrated portfolios, which can generate higher costs and undermine the goal of pursuing expected return premiums.
Index managers attempt to closely track a commercial benchmark. But the emphasis on low tracking error puts them at a trading disadvantage since they must buy and sell securities when the index is reconstituted (rebalanced). Infrequent rebalancing can result in style drift as securities change characteristics and the portfolio moves away from its targeted universe.
A scientific approach focuses on holding areas of the market that have offered higher expected returns. The approach is informed by financial science and the view that market prices reflect all available information. Rather than chasing returns through stock picking and market timing, the manager looks to academic research to gain insight into the dimensions that drive expected returns, then integrates this knowledge into strategies designed and implemented to add value in competitive markets.
Most firms are still trying to sell the idea that they can find mispriced stocks or time the market. That is not the way we approach investing at Fortress Planning. The foundation of our investment approach is that markets are efficient. Fortress Planning principal Scott Wellens, CFP® spent hundreds of hours and combed through dozens of academic peer reviewed research papers to discover this. Why it matters for you: If you already know that markets are priced fairly, then you can turn your attention to other ways to gain a competitive advantage in the market. That’s what we aim to do at Fortress Planning.
About the author, Scott Wellens
Scott Wellens, CFP® is an investment advisor and founder of Fortress Planning Group. After earning his Bachelor of Science degree from the University of Wisconsin-Oshkosh, Scott quickly ascended to become a Vice President of North American Sales at a major regional provider of telecommunications infrastructure. While financially successful in this role, Scott searched for ways to pursue his passion related to financial literacy and providing financial freedom for both his own family and others. During his search, Scott became curious about the significant gap he found in the financial services sector: he was unable to find a comprehensive financial planner that maintained a family stewardship lens without being attached to financial products. Scott decided to fill that gap by creating his own planning firm that maintains a strong passion for comprehensive, unbiased wealth planning that is genuinely client-centered.
Scott resides in Menomonee Falls, WI with his family. He is the father of three active and independent daughters who keep him on his toes. Scott is an active community member, serving on the Hamilton Education Foundation Board, serves as a Dave Ramsey Financial Peace facilitator and leads the All Pro Dad’s group at their local elementary school. Scott enjoys spending his free time visiting state parks with his family, reading, and watching the Milwaukee Bucks and the Green Bay Packers win ball games.