How Markets Work

Advanced Financial Planning | Global Economy

 Peter Lazaroff By: Peter Lazaroff

My father-in-law, Tom, is the king of buying and selling used cars. Every two or three years he sells his car and buys another used car. And if he doesn’t come out ahead every time, he seems to at least break even.

For years I’ve been using Tom and his cars as an example of how markets work. Here’s what I mean:

Let’s say Tom offers to buy my car for $10,000 and then sells it to my neighbor Bill for $20,000. In this scenario, Tom doubled his money overnight – but he probably couldn’t make that kind profit if Bill and I had access to market data on used car pricing.

In a different scenario, I could take Tom’s offer and then compare it to other prices that cars like mine have recently sold for (thanks to the ability to easily research this information online). Maybe I could see used cars like mine usually sold for $19,000 to $21,000.

If I needed cash fast, I could agree to sell the car to Tom 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.

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

Instead, Bill could choose to wait until someone offers him a similar car for $19,000 or until Tom drops the price.

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

In real life, there are likely to be more buyers and sellers in the used car market than just Tom, Bill, and myself. This could impact what I sell my car to Tom for, and what Bill is willing to buy it for even when we all have access to the same data on the market.

If the market had lots of sellers and a shortage of buyers, Bill could likely get the car for a lower price – from Tom or someone else willing to accept less profit. If Tom had the only car and there were many buyers, though, he would have the advantage and could sell at a higher price.

This example demonstrates a very 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 that price being “fair.”

In Tom’s case, he had a good chance of “beating the market” when Bill 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, Tom will have less of an opportunity to make a big profit.

It used to be easier to outsmart the used car market and flip cars the way my father-in-law did, but competition for used car profits is high and the amount of available information to inform buyers and sellers has skyrocketed in the past decade.

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

Why Beating the Market Is Harder Than You Think

People tend to respect the power of supply and demand in markets in their everyday life, but that respect seems to break down when it comes to financial markets. The stock market is much like any other market of buyers and sellers.

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. As a result, information is quickly incorporated into 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 wealth over the long-term.

Rather than compete with the market, you can improve your chances for success by using a strategy that lets the market work for you.

Want to learn more? I’m writing a book that explains how to leverage the power of markets in your portfolio to enhance your ability to reach your financial goals. Sign up here for updates and exclusive offers leading up to the 2019 release.

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Peter Lazaroff, Chief Investment Officer, first took an interest in investing when his grandmother gave him a single share of Nike stock for his 13th birthday. Today, nearly 20 years later, his investment insights are highly sought after by local and national media. More »

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