A Question of Equilibrium

“Sellers were out in force on the market today after negative news on the economy.” It’s a common line in TV finance reports. But have you ever wondered that if there are so many sellers out there, who is buying?

The notion that in down days sellers outnumber buyers doesn’t make sense. What the newscasters should say, of course, is that prices adjusted lower because would‑be buyers weren’t prepared to pay the former price.

What happens in such a case is either the would-be sellers sit on their shares or prices adjust to a point where supply and demand come into balance. Buyers eventually invest if the price is low enough. This is when transactions occur and is described by economists as “equilibrium”.

But the price at which equilibrium is reached can change. That’s because new information is coming into the marketplace continually, forcing would-be sellers and would-be buyers to constantly adjust their expectations.

That new information might be company-specific news on earnings. It might be news that has implications for specific industries—like a spike in oil prices. Or it might be an economic development that affects the entire market, like a change in the unemployment rate.

Given this constant flux in the flow of news and information and the changing expectations of participants, it can be reassuring to know that for everyone selling shares there must also be buyers. Otherwise, the trade would never take place. And whenever information changes, prices may change and quickly reach a new level of equilibrium.

Here’s an example from outside the share market to explain how market equilibrium works: Back in early 2011, a cyclone devastated about 75% of the banana crop in the Australian state of Queensland, which produces more than 90% of the national crop.

With supply short, retail prices for the fruit soared from around $3 to nearly $15 a kilogram within months. Farmers who had already harvested their crops sold at significant margins. Many consumers stopped buying bananas altogether because the prices were just too high for their tastes.

But then prices stopped rising as consumers pulled away from the market. And, as full supplies slowly returned, prices gradually fell to end the year back down where they began.

Similarly, security prices rise and fall continuously based on a multiplicity of influences, including supply and demand, news about the individual company and its industry, developments in the economy or even general expectations about the share market.

Trying to untangle all these influences and profit from perceived mispricing is not possible in a systematic and scalable way.

An alternative approach is to start by accepting that prices are fair and point to the collective expectations of market participants. While information frequently changes, this is quickly built into prices. Competition among buyers and sellers is such that it’s not possible to consistently outguess the market.

The second step is see that fairly-priced securities can have different expected returns. And we can use market prices and security characteristics to identify those securities that offer higher expected returns.

The third step is to build highly diversified portfolios around these broad drivers of return, while implementing efficiently and managing the cost of buying and selling securities.

The final step is staying disciplined and rebalancing your portfolio to stay within your chosen risk parameters or to adjust for changes in circumstances.

Ultimately, the market is like a giant information processing machine. All those influences mentioned above are constantly being assessed by millions of participants. And prices constantly adjust based on those collective expectations.

The premiums we expect from investing are not there every day, every month, every week or even every year. But the longer we stay invested, the more likely we are to capture them.

So, rest assured, even when prices are falling there are still people buying. The market is doing its job and the rewards will be there if you remain disciplined.