How markets work

Let’s use a car analogy

James is the king of buying and selling used cars. Every 2 or 3 years he sells his car and buys another used car. If he doesn’t make a profit each time, he always seems to at least break even.

If James offers to buy my car for £10,000 and then sells it to my neighbour Jenny, for £20,000, overnight James has doubled his money. But he probably couldn’t make that kind profit if Jenny had had access to market data on used car pricing.

In a different scenario, I could take James offer and then compare it to other prices that cars like mine have recently sold for (thanks to easy-access information online). My research showed me I could potentially sell my car for between £19,000 to £21,000.

If I needed to sell quickly, I could agree to sell the car to James for £19,000. If I had more time to be patient, I could probably find a buyer and sell the car for a higher price.

James could then go to Jenny, who also had access to market data on used cars. Jenny could see that the most recent transaction for a car of my make and model was £19,000. If Jenny wasn’t in a hurry to buy a car, she won’t buy from James for £20,000.

Instead, Jenny could choose to wait until someone offers her a similar car for £19,000 or until James drops the price.

Longhurst - Investment Management

Back to the Basics: Price and the Impact of Supply and Demand

In reality there are likely to be many more buyers and sellers in the used car market than just James, Jenny, and I. This could impact what I sell my car to James for, and what Jenny is willing to pay James for it.

If the market had a large amount of sellers, and a shortage of buyers, Jenny could most likely get the car for a lower price, whether that be from James or someone else willing to accept less profit. If James had the only car in the market, and there were lots of buyers, he would have the advantage and could sell at a much higher price.

This example demonstrates a simple market in which participants with different objectives, and varying levels of information, set prices through the basic forces of supply and demand. The more people that participate in the market, the more information that gets incorporated into the eventual transaction price, and the more confident we are in getting a ‘fair’ price.

In James case, he had a good chance of “beating the market” when Jenny and I were the only other participants, particularly if we didn’t have information from the internet at our disposal. But if more buyers and sellers of used cars enter the market, James will have less of an opportunity to make a big profit.

So what does all this have to do with the stock market?

Longhurst - An Emoji Guide to Investing

Why Beating the Market Is Harder Than You Think

The stock market is much like any other market of buyers and sellers. And yet, as logical people, we tend to think we can beat the financial markets, even though it’s powered by the same supply and demand factors we face in everyday life.

In 2017, the global stock market had 76.5 million trades per day worth $441 billion dollars. The market prices you see at any given moment reflect the buying and selling by millions of market participants incorporating all known information about a company.

These market participants are collectively highly educated and highly motivated. And as a result, information is quickly incorporated into market prices.

While it’s natural to want investments that beat the market, being a successful investor doesn’t necessarily require you to find a manager that outperforms. Most investors that take this route underestimate the competition within financial markets and overestimate the opportunity for excess return.

Although the odds of any investor consistently outsmarting the market are very slim, that doesn’t mean you shouldn’t invest. It simply suggests that actively trying to beat the market isn’t a smart strategy if you want to focus on building long-term multi-generational wealth.

Rather than compete with the market, you can improve your chances for success by simply embracing market returns, accepting the temporary and very normal declines, and focus on more important things – like your family, or hobbies, or travel.

Want more proof?

Take a look at our Investment Principles page, with supporting video produced by Dimensional Fund Advisors.

Optimism is the only realism. Understanding this is wisdom.

Click here