Whenever we have a mental block when trying to grasp an important concept, it sometimes helps to be presented with an image or a visual metaphor.
A good example of a concept that investors often struggle with is the idea that financial markets are highly competitive and that prices are the best estimate we have of future returns.
That may be because much of the financial media is built on the assumption that you can profit consistently from mistakes in share prices, despite the mountain of research showing that even the professionals struggle to do that.
One response to that is to talk about the wisdom of crowds. Remember that TV show, Who Wants to be a Millionaire? Contestants stumped for an answer are given three lifelines — 50/50 (two choices), phone a friend, or ask the audience.
According to author James Surowiecki phoning a friend will give you the right answer about two thirds of the time — better than the 50/50 option. But asking the audience yields the right answer more than 90% of the time.
Accepting market prices is like asking the audience. They’re never going to be perfectly right, but it’s the best barometer we’ve got. And by not trying to work it out all on your own, you’re freed up to focus on all the things you can control.
A marketplace aggregates lots and lots of information very efficiently. The TV studio audience in this case is like all those buyers and sellers in the share market. No single person has got all the information, but together they get close to the truth. In investing, that truth is reflected in the price.
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