Profiting from price discovery

Events tend to throw the world into chaos. With the world in chaos, the stock markets inevitably see mayhem. The mayhem in Europe in recent weeks is only evidence of one thing. The more things change in the world, the more our behavior towards investments remains the same. I remember every single crisis in the financial world since I started investing in 1990. The stock market behavior has been identical through every crisis. Panic will be the first reaction. The bad news will slowly sink in and gain acceptance. Then for a prolonged period of time, investors wait for a similar event to recur. Nothing of that sort would happen when investors expect it to recur. The investors gradually get convinced that their fears are unfounded and the fears gradually recede. Once the fears recede, more investors step out and take risks again. Over a period of time, the tribe of risk takers keep growing until it becomes a mob of possessed people unwilling to listen to saner voices. This mob is finally controlled by the next phase of chaos which is created by their behavior itself. This cycle virtuously plays out in the stock market almost every decade. Yet, investors hardly seem to learn and only create a bigger problem by showing greater irrationality.

Is the stock market only a place where one loses his money? Certainly not. The capital market is a principally a wealth creator. It is the investors who destroy the wealth created in the capital market by over doing things and behaving irrationally. Rational behavior is easier said than practiced. The stock markets are better known for irrationality than for logical reasoning. But, that has to do with the people who come to the stock market seeking irrational returns and has little to do with the mechanism of the stock market itself . The stock market mechanism is a great way of creating wealth and discovering the fair value of businesses. It is a free market where buyers and sellers decide the value of a company by trading freely and discovering the price of a stock. The way in which the prices grow closer to the fair value is called price discovery. This process of price discovery is meant to evolve into an efficient one over a period of time. The same process of price discovery can go wrong when investors tend to flock towards a single stock or sector without judging the fair price of the business. But, that is not so important as the positive things that the price discovery process does to stabilize the valuation of a company and to discover it fairly.

Investors must focus on the price discovery aspect squarely and ignore the market perception of a stock. When there is chaos, the weakest valuation of a business prevails. At this point , all the negatives of the business are factored into the price. The price discovery process actually favors the buyer and irrationality is favorable to buyers. By locking in at those prices, investors can take advantage of the irrationality in the price discovery process. Investors must principally focus on this process of price discovery and take advantage of this process to make his investing work .The IPO is another instance of price discovery. Usually, IPO’s start at a price fixed by the merchant bankers. This is not necessarily a fair value. But, the trading after listing allows investors to gradually discover the fair price of the stock. As results are declared and the fundamental of the company understood fully by the investing public, the price discovery of the stock will become more and more mature. The fair value of the company is obtained by discovering the price of the stock over a prolonged period of trading.

The beauty of the price discovery process in the stock market is its transparency. Most factors are clearly known. The prospectuses of companies are freely available. Their annual reports are all online. The supply of stock is clearly known. The demand is open for all to see. The trading volumes and their delivery percentages give a clear idea of the speculative factors built in the price. All announcements are available to investors and there is no information gap. Any speculative surge is swiftly controlled by the exchange’s volatility management system. Bubbles in stock prices can easily be traced even as they form. The increasing systemic controls in the stock market have ensured that the scope for bubbles are minimized due to the trading platforms and the way stock exchanges function. Transparency is a key tool in this process.

The price discovery process is what has made stock investing much safer in the past decades. Investors must learn how to sue this process for their benefit and to steer clear of investments which are trading at irrational prices due to speculative trading. The process clearly tells us when something is wrong. It is up to us to avoid the traps and keep our investing out of the danger areas.

Happy investing!

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