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Investing

Why Passive Investors Always Get the “Right” Price

Market expectations are typically already factored into market prices, so passive investors don’t have to try to make predictions in an unpredictable environment.

Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: March 30, 2015

Market prices may already reflect the consensus view on future events—so correctly predicting something that was already ‘priced in’ isn’t necessarily profitable.

With millions of active traders trying to find the ’right’ price, odds are the current price is ‘right.’ You’re better off staying the course.

If you’re even a casual observer of the markets, you’ve probably noticed scenarios like this play out: The Federal Reserve meeting on interest-rate policy is approaching. The closer it gets, the more economists express conviction that the central bank will cut rates, benefiting the economy and stock market. The big day arrives, the Fed cuts rates, as expected…and stocks take a big dive.

Or, say a big company is about to release financial results for the latest quarter. The consensus among analysts is that it will earn, for example, $6.30 a share. When the report is issued, the figure is $6.30, maybe a penny or two either way… and the share price takes a big dive.

What’s happening here is a phenomenon called news being ‘priced in,’ which is when the price already reflects the market’s valuation of the stock, including the event. Active traders can get easily burned trying to predict these minor price fluctuations—but passive investors who sit on the sidelines get the ‘right’ price without having to bear the risk or do the work.

market prices

The Game of Fair Pricing

You’ll often hear commentators say that “investors had already priced in” some positive economic or corporate announcement or else that “it was already in the price.” What they mean is that it had been so widely anticipated that investors were trying to front-run it, or buy beforehand, so the price of the stock or market fully—maybe more than fully—reflected the good news.

Sometimes analysts, strategists, and the media create alternative narratives to try to make sense of the market reaction: The rate cut may signal the Fed’s belief that the economy isn’t all that strong, for instance. But the pricing game has been common enough for long enough to have produced a widely accepted bit of wisdom on Wall Street: “Buy on mystery, sell on history.”

Flip the switch, make the news bad instead of good, and you’ll see a mirror image of the phenomenon. An event that investors have been dreading comes to pass and the market or security in question rallies inexplicably.

Remember 2013?

Think back to the summer of 2013. When the Fed announced that it would buy Treasury and mortgage bonds at a rate of about $1 trillion a year, a reasonable deduction was that the weight of all that buying would send bond prices higher and yields lower. But yields rose sharply. This is in stark contrast with widely used models of the bond market.

An excuse offered at the time was that investors assumed that the program, known as quantitative easing, would boost the economy and raise expectations for inflation, which in turn would send interest rates up. Fair enough, but it’s also true that Treasury yields were close to all-time lows when the program was announced. The Fed’s move was already in the price.

The Fed reversed course and spent most of 2014 curtailing, and eventually ending, quantitative easing. You might have expected that to push Treasury yields up as the central bank’s bond purchases diminished. But yields have been sinking all year. Perhaps investors are concerned about a softening of economic growth with less Fed support, or perhaps the well-telegraphed conclusion of the bond purchases was in the price, too.

The way that investors have factored Fed policy into their thinking ever since the end of the recession in 2009 highlights another drawback—in this case a big and persistent one—to making portfolio decisions based on forecasting the outcome of a big development: Sometimes the big development just doesn’t happen.

Once the Fed had dropped short-term interest rates essentially to zero in response to the financial crisis and later introduced quantitative easing, investors reasoned—not without justification—that, short-term blips aside, bond prices had to fall when the Fed reined in its influence and normal market activity resumed. But the Fed has been far more reluctant to let the market stand on its own than almost anyone foresaw, and many of these investors have steadfastly, even stubbornly, refused to own bonds throughout this period.

It’s almost certain that they’ll be proven right eventually, but eventually can take a very long time to arrive, and sometimes being right isn’t profitable. In the meantime, they have missed out on healthy gains in the bond market and, more importantly, they have exposed their portfolios to undue risk by not being properly diversified.

Be careful what you wish for.

Markets often act in surprising ways when investors get what they expect or when there’s no news at all. What about when there is news, but it defies forecasts, falling short of positive expectations or not being as bad as had been feared? When new information is unexpected, the reaction tends to be, well, about what you’d expect.

If prices can move the same way whether a forecast proves accurate or not, it may encourage clever investors to go for a quick score by betting against the grain ahead of a big announcement. If it comes in as expected, it may be in the price, and if the consensus is fooled, perhaps they’ll benefit from the surprise. It’s a sure thing, right?

Don’t let one data point fool you.

Probably not. First of all, whatever the data point in question is, it’s not the only factor affecting companies and markets. Also, news being priced in doesn’t always happen; share prices often react to news the way logic would dictate.

Another consideration is that even if it’s possible to capture a short-term price blip, it may prove to be just that—an ephemeral reaction that dissipates in the days or weeks ahead, leaving traders worse off than if they had taken no action.

And the big picture is what you should focus on. Some professional speculators may get lucky playing price swings like these, but if you’re investing for the long haul, they’re too small to bother with, especially in relation to the costs—in brokerage commissions, time and sanity—needed to capture them effectively. Instead, you’re better off sticking with the goals you set and the steady, disciplined approach you promised to take when you put your money to work in the first place.

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