The Power of Markets

by James McFarland, Senior Portfolio Manager.

In 1958, economist Leonard Read published an essay entitled “I, Pencil: My Family Tree as Told to Leonard E. Read.”

The essay, narrated from the point of view of a pencil, describes the “complex combination of miracles” necessary to create the commonplace writing tool that has been used for generations. The narrator argues that no single individual possesses enough ability or know-how to create a pencil on their own. Rather, the mundane pencil—and the ability to purchase it for a “trifling” sum—is the result of an extraordinary process driven by the knowledge of market participants and the power of market prices.

PENCILS AND PRICE

When looking at a pencil, it’s tempting to think that a single person could go make one. After all, it’s a pencil! How complex could it be?  It’s only in delving deeper that we can realize how all the seemingly ordinary components have to come together in just the right way that we can begin to understand what’s really going on.

Take the wood as an example: To produce wood requires a saw, to make the saw requires steel, to make steel requires iron. That iron must be mined, smelted, and shaped. A truck, train, or boat is needed to transport the wood from the forest to a factory where numerous machines convert it into lumber. The lumber is then transported to another factory where more machines assemble the pencil. Each of the components mentioned above and each step in the process have similarly complex backstories. All require materials that are sourced from far-flung locations, and countless processes are involved in refining them.

And while the multitude of inputs and processes necessary to create a pencil is impressive, even more impressive are the coordinated actions required by millions of people around the world to bring everything together! There is the direct involvement of farmers, loggers, miners, factory workers, and the providers of capital. There is also the indirect involvement of millions of others—the makers of rails, railroad cars, ships, and so on. Market prices are the unifying force that enables these millions of people to coordinate their actions efficiently.

Workers with specific knowledge about their costs, constraints, and efforts use market prices to leverage the knowledge of others to decide how to direct their own resources and make a living. Consider the farmer, the logger, and the price of a tree. The farmer will have a deep understanding of the costs, constraints, and efforts required to grow trees. To increase profit, the farmer will seek out the highest price when selling trees to a logger.

After purchasing the trees, the logger will convert them to wood and sell that wood to a factory. The logger understands the costs, constraints, and efforts required to do this, so to increase profit, the logger seeks to pay the lowest price possible when buying trees from the farmer. When the farmer and the logger agree to transact, the agreed upon price reflects their combined knowledge of the costs and constraints of both growing and harvesting trees. That knowledge allows them to decide how to efficiently allocate their resources in seeking a profit. Ultimately, it is price that enables this coordination.

On a much larger scale, price formation is facilitated by competition between the many farmers that sell trees to loggers and between the many loggers that buy trees from farmers. This market price of trees is observable and can be used by others in the production chain (e.g., the lumber factory mentioned above) to inform how much they can expect to pay for wood and to plan how to allocate their resources accordingly.

THE POWER OF FINANCIAL MARKETS

The above narrative is like an allegory for how financial markets work. Just as with the millions involved in the creation of a pencil, financial markets are also made up of millions of participants, and these participants voluntarily agree to buy and sell securities all over the world based upon their own needs and desires. Each day, millions of trades take place, and the vast collective knowledge of all of these participants is pooled together to set security prices. Exhibit 1 shows the staggering magnitude of participation in the world equity markets on an average day in 2015.

Any individual trying to outguess the market is competing against the extraordinary collective wisdom of all of these buyers and sellers. Viewed through the lens of our pencil allegory, attempting to outguess the market is like trying to create a pencil from scratch rather than going to the store and reaping the fruits of others’ willingly supplied labor.

In the end, trying to outguess the market is incredibly difficult and expensive, and over the long run, the result will almost assuredly be inferior when compared to a market-based approach. Kenneth French has been quoted as saying, “The market is smarter than we are and no matter how smart we get, the market will always be smarter than we are.” One doesn’t have to look far for data that supports this. Exhibit 2 shows that only 17% of US equity mutual funds have survived and outperformed their benchmarks over the past 15 years.

PUTTING THE POWER OF MARKETS TO WORK

The beauty of Leonard Read’s story is that it provides a glimpse of the incredibly complex tapestry of markets and how prices are formed, what types of information they contain, and how they are used.

The story makes it clear that no single individual possesses enough ability or know-how to create a pencil on their own but rather that the pencil’s miraculous production is the result of the collective input and effort of countless motivated human beings. In the end, the power of markets benefits all of us.

The market allows us to exchange the time we require to earn money for a few milliseconds of each person’s time involved in making a pencil. For an investor, we on the investment team believe the lesson here is that instead of fighting the market, most investors should pursue an investment strategy that efficiently and effectively harnesses the extraordinary collective power of market prices. Instead of fighting markets, put the power of markets to work for you. Our Core4 strategy embraces this approach, and we utilize tools that incorporate the use of market prices and the information they contain when constructing client portfolios. We believe this gives our clients better odds of achieving their vision.

Leonard Read’s essay can be found here: http://econlib.org/library/Essays/rdPncl1.html

Sources/Data provided by: Dimensional Fund Advisors LP.

There is no guarantee investment strategies will be successful.

US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. Certain types of equity funds were excluded from the performance study. Index funds, sector funds, and funds with a narrow investment focus, such as real estate and gold, were excluded.

Funds are identified using Lipper fund classification codes. Correlation coefficients are computed for each fund with respect to diversified benchmark indices using all return data available between January 1, 2001, and December 31, 2015. The index most highly correlated with a fund is assigned as its benchmark. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.

Views and opinions are subject to change. Data cited is believed to be reliable but is not guaranteed. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investing involves risk and past performance does not guarantee future return.

Ken French is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP.