How Many Jellybeans Does it Take to Price a Stock?
Imagine a jar is filled with a large number of jellybeans and you have to guess the quantity that is inside the jar. It would be a daunting task for anyone. After all, this isn’t something that is necessarily practiced or reduced to a science. But, this exercise can offer valuable insight into how stock market prices are set, and if they are fair and accurate.
The main question to be explored in this article is “Do markets do a good job of pricing securities?” Are there individuals out there who are better at estimating the value of a particular stock than the market? Can those individuals use their knowledge or a secret algorithm to identify stocks that are “under-valued” and thus, purchase those stocks with the expectation of receiving superior returns?
There are usually two schools of thought on this topic. One group will attest that there are, indeed, inefficiencies that exist in the pricing of securities, allowing savvy investors to identify and capitalize on “cheap stocks.”
The other theory is that markets are efficient in pricing securities. In other words, this group believes there is enough information available to enough investors to set a fair and accurate price. They believe that as soon as information is released and becomes available to the public, the information is processed by the masses and is used in immediately generating a new price for the security. Simply put, if you believe if this method, you believe that a stock’s price is the best reflection of its inherent value.
Now vs. Then
In this debate, it’s important to consider just how the financial landscape has changed with the continued advancement of technology. Decades ago, before the days of the internet, information traveled slower. The average investor relied on newspapers to check stock prices day-to-day. Trades were traditionally placed through a stock broker.
Today, more and more investors are getting access to data quicker and easier than ever before. Retail trading platforms are more user-friendly than ever. Trades can be placed by phone, computer, tablet, etc. The result is that it has become incredibly more challenging to take advantage of price discrepancies in the market.
Garage Sale Pricing
On that note, just how quickly do securities actually reach a fair price? Let’s consider this example. You are hosting a garage sale for your deceased relative. One of the items you put up for sale is an old painting. However, little do you know that this particular piece of art is an original piece from a famous artist, valued at $10,000. You set the price at $10. An art connoisseur comes along, recognizes that piece, and says he will gladly pay $10, while trying not to draw too much attention to himself.
Just before you make the transaction complete, another art enthusiast, also recognizing the value in this piece, offers up $100. Before you know it, a bidding war has begun, pushing the price much closer to its fair value. In this case, it took only two market participants to drive the painting much closer to its actual value. In other words, getting to the actual value happened fast once the information was made available to multiple market participants.
Back to the Jellybeans
The theory behind efficient markets can also be illustrated by playing the jellybean game. If you fill a jar of jellybeans and collect estimates on how many are actually in the jar, you may be surprised to find the average of all guesses is incredibly close to the actual number in the jar.
Why does this matter for investors?
Stocks are priced based on a multitude of different factors and fundamentals. The stock market is one of the most powerful information processing machines in existence. All available information translates into a company’s equity, its prospects for future earnings, and perceived risk. Thanks to the market’s processing power, we believe we can treat the current price of a stock as a fair estimate its actual value.
In other words, each stock can be considered its own jar of jellybeans. There will be many investors that come along and provide their best guess on what the stock is worth. Investors “vote” on what they think the stock is worth by buying or selling the stock. The average of all those votes (in simplistic terms) becomes the current price of the stock.
And remember, investor estimates of a proper stock price would encompass every piece of public information available. This would include particular headwinds the stock may face, legislative concerns, rumors of a merger, etc. However, all investors have access to and are accessing the same information when placing their votes. In this information age we are in, there are no secrets about stocks, only fundamentals and future projections.
Trying to be better at valuing stocks than the market is a tall task. It’s like betting that you’ll do better at guessing how many jellybeans are in the jar instead of going with the average guess of thousands of market participants. When you compete against the market, you are competing against the collective knowledge of all investors. With as quickly as information travels in today’s market environment, it’s hard to imagine that any publicly traded stock is “hiding” and not reflecting what investors think to be its fair value.
This is even true for stocks that aren’t as popular or traded as often. After all, it only took two patrons to properly price your famous painting.