The Power of Markets: Part 2
In 1958, economist Leonard Read published an essay entitled “I, Pencil: My Family Tree as Told to Leonard E. Read.”
by, Jeremiah Pizana, exclusive to Corridor News
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In part one, we considered the concept of The Importance of Price. Specifically, around the creation of a pencil. Now we will expand on the power of financial markets.
THE POWER OF FINANCIAL MARKETS
There is a corollary that can be drawn between this narrative about the market for goods and the financial markets. Generally, markets do a remarkable job of allocating resources, and financial markets allocate a specific resource: financial capital.
Financial markets are also made up of millions of participants, and these participants voluntarily agree to buy and sell securities all over the world based upon their own needs and desires. Each day, millions of trades take place, and the vast collective knowledge of all of these participants is pooled together to set security prices.
Exhibit 1 below, shows the staggering magnitude of participation in the world equity markets on an average day in 2015.
Exhibit 1. Embrace Market Pricing
In US dollars. Global electronic order book (largest 60 exchanges). Source: World Federation of Exchanges.Any individual trying to outguess the market is competing against the extraordinary collective wisdom of all of these buyers and sellers.
Viewed through the lens of Read’s allegory, attempting to outguess the market is like trying to create a pencil from scratch rather than going to the store and reaping the fruits of others’ willingly supplied labor.
In the end, trying to outguess the market is incredibly difficult and expensive, and over the long run, the result will almost assuredly be inferior when compared to a market-based approach.
Professor Kenneth French has been quoted as saying, “The market is smarter than we are and no matter how smart we get, the market will always be smarter than we are.” One doesn’t have to look far for data that supports this.
Exhibit 2 below, shows that only 17% of US equity mutual funds have survived and outperformed their benchmarks over the past 15 years.
Exhibit 2. Don’t Try to Outguess the Market
Beginning sample includes funds as of the beginning of the 15-year period ending December 31, 2015. Past performance is no guarantee of future results. Source: Dimensional Fund Advisors, “The US Mutual Fund Landscape.” See disclosures for more information.CONCLUSION
The beauty of Leonard Read’s story is that it provides a glimpse of the incredibly complex tapestry of markets and how prices are formed, what types of information they contain, and how they are used.
The story makes it clear that no single individual possesses enough ability or know-how to create a pencil on their own but rather that the pencil’s miraculous production is the result of the collective input and effort of countless motivated human beings. In the end, the power of markets benefits all of us.
The market allows us to exchange the time we require to earn money for a few milliseconds of each person’s time involved in making a pencil. For an investor, we believe the lesson here is that instead of fighting the market, one should pursue an investment strategy that efficiently and effectively harnesses the extraordinary collective power of market prices.
That is, an investment strategy that uses market prices and the information they contain in its design and day-to-day management. In doing so, an investor has access to the rewards that financial markets make available to providers of capital.
If any questions arise from reading this article, please feel free to reach out. My firm offers a holistic financial planning approach and investment management services for its clients.
Leonard Read’s essay can be found here: http://econlib.org/library/Essays/rdPncl1.html.
To read The Power of Markets: Part 1 click HERE.
Jeremiah Pizana is a financial planner who owns Liberty Crown Financial located in San Marcos, Texas and is an exclusive contributor to Corridor News. Liberty Crown Financial was founded with the distinct purpose of providing clients with the resources necessary to pursue a life of financial independence and prosperity. Jeremiah is an exclusive contributor to Corridor News and you can read additional columns from Jeremiah under our Business Section.
Source: Dimensional Fund Advisors LP. Dimensional Fund Advisors LP is not affiliated with Royal Alliance Associates, Inc There is no guarantee investment strategies will be successful.
US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. Certain types of equity funds were excluded from the performance study. Index funds, sector funds, and funds with a narrow investment focus, such as real estate and gold, were excluded.
Funds are identified using Lipper fund classification codes. Correlation coefficients are computed for each fund with respect to diversified benchmark indices using all return data available between January 1, 2001, and December 31, 2015. The index most highly correlated with a fund is assigned as its benchmark. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products or services. Ken French is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP. Securities and advisory services offered through Royal Alliance Associates, Inc., member FINRA/SIPC and a registered investment advisor. LibertyCrown Financial is a marketing name. Certain insurance offered through Jeremiah Pizana is independent of Royal Alliance Associates, Inc.
