Key Investment Insights: News and Market Prices
August 5, 2014
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Welcome to the second installment in our series of Key Investment Insights.
In our last post, “Market Prices,” we explored how group intelligence can govern relatively efficient markets in an imperfect world. Today, let’s look at how prices are set moving forward. This, too, helps us understand how to play with rather than against the wisdom of the market, as you seek to improve your investment results.
What causes market prices to change? It begins with the fundamentals, or what is considered the never-ending stream of news and data which informs us of the good, bad and ugly events that are or will shortly be taking place. Let’s say, for example, that the U.S. Department of Agriculture issues a report that a fungus is attacking Florida’s citrus crop; as a result, orange juice futures may soar, as the market’s collective wisdom predicts that there is going to be less supply than demand.
But what does this mean to you and your investment portfolio? Should you buy, sell or just hold tight? Before the news tempts you to jump into or flee from a breaking trend, it’s critical to be aware of the evidence that tells us the most important thing of all: You cannot expect to consistently improve your outcomes by reacting to breaking news.
How the market adjusts its pricing is why there’s not much you can do in reaction to breaking news. There are two principles to bear in mind here.
First, it’s not the news itself; it’s whether or not you saw it coming. When a security’s price changes, it’s not because something good or bad has happened. It’s generally because the next piece of news, good, bad or even neutral, is better or worse than expected. If, in the aforementioned example, it’s reported that the citrus fruit disease is continuing to spread, changes in pricing may be minimal because everyone had already been expecting doom and gloom. On the other hand, if news of an ingenious new fungicide is released, prices may change dramatically in reaction to the unexpected and possibly swift resolution.
Thus, it’s not just news, but unexpected news which alters pricing. By definition, the unexpected is impossible to predict; moreover, how the market responds (or fails to respond) to it is another uncertainty.
The Barn Door Principle
The second reason to consider breaking news as irrelevant to your investing strategy is “The Barn Door Principle.” By the time you hear this so-called “breaking” news, the market has already priced it in, well ahead of your ability to do anything about it. Thus, those proverbial horses have long since galloped past your open trading door.
This is especially true in today’s micro-second electronic trading world. In his article, “The impact of news events on market prices,” CBS MoneyWatch columnist Larry Swedroe explored how fast global markets respond to breaking news. Pointing to evidence from numerous studies among several developed markets, the universal response was nearly instantaneous price-setting during the first few post-announcement trades. As Swedroe concluded, “since current market prices already incorporate all that is knowable, the next piece of news is random in terms of whether it is better or worse than the market expects, and the market adjusts almost instantly to that news.”
Unless you happen to be among the very first to respond to breaking news (and mind you, you will be competing against automated traders who generally can and do respond in fractions of milliseconds), you will likely be too late to take advantage of any breaking news.
Rather than try to play a potentially very expensive game based on ever-changing and uncontrollable information, the preferred way to position your life savings is according to a number of market factors that you can better expect to manage in your favor. In future Key Investment Insights, we’ll introduce these factors to you.
But first, you may be asking yourself this question: Although you might not be up to the challenge of competing against the market, what’s to stop you from having a pinch-hitting expert compete for you? In our next Key Investment Insight, we’ll explore how well that tactic has worked in the past.
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