Wednesday, October 13, 2010

How Do Markets Work?

The past few years we have experienced an extreme down market and an extreme recovery. The only constant has been volatility. Add a loaded political environment, multiple wars and media amplification and it’s easy to lose sleep. If you have been able to ignore the noise – great! If you haven’t, then understanding markets can be a quality of life decision.

Why is the stock market unpredictable? The simplest answer; because expected information, good or bad, does not move the market. Unexpected information moves the market. Unless you can expect the unexpected, markets are unpredictable.

Why does the market move higher on the news of rising unemployment? To understand this it helps to differentiate the stock market from the economy. Remember, the stock market is a predictor of the economy; the economy is not a predictor of the stock market. Markets moved higher because markets expected a greater rise in unemployment. Rising unemployment was already factored into the market price. The bad news was better than expected.

Today’s expected news was accounted for weeks or months ago. Today’s unexpected news is accounted for today. We don’t know what tomorrow will bring. More importantly, it is all noise if you aren’t selling. Understanding these nuances can prevent media reports from leading to speculative mistakes. Understanding markets allows us to consider all outcomes and plan accordingly. Time is the answer. Portfolio design is the answer. Quality of life is the goal.

The stock market is an extremely complex mechanism. It is likely there are some pricing inefficiencies in markets. However, discovering them and capitalizing on them is difficult to impossible. For more detailed information regarding these concepts visit our website or Dimensional’s website.

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