Let’s Try this Market Metaphor

Imagine that instead of a stock market, all stock prices are decided by a committee of ten men. Inside a big room, ten guys who all look somewhat look like the Monopoly Man convene once a day. They judge each stock and the average of their decisions is the stock’s price.

Let’s say that for one particular stock, the committee rules as follows. Two members say it’s worth $23 per share. Two more say it’s worth $24. Four members say $25. One says it’s $26.

That leaves one more member. He says stock is worthless. $0 per share.

Thanks to the ultrabear, the average of the ten comes to $22 per share.

It’s this one bearish outlier that’s our very good friend. Because of this spread, the prices underlying the stock’s price aren’t normally distributed. There’s a small fear of disaster. Even though the fear is small, it weighs heavily on the share price.

Although this is just a thought exercise, I like it because it elucidates a broader truth about the market. Every stock has a fear premium built into its price. Most of the market’s gains come from the slow, incremental advance in the judgment of the vast majority of the market. The sudden downshifts are when the lone dissenter is able to get a few more people into his camp. And very rarely, everyone joins his camp.

This is why changes in stock prices don’t follow the normal bell curve. As a very general rule of thumb, stock prices go up slowly and fall rapidly. In fact, bear markets are often largely done right at the point the public realizes they’re in one.

What value investing does, in essence, is constantly short the fear premium—that one $0 guy. It’s not the nine people paring back their view that creates opportunity. If the market is efficient, it’s those nine guys who are. The inefficiency happens when the fear premium jumps.

Posted by on June 22nd, 2015 at 12:06 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.