Democracies are controlled by votes. All votes are equal. But, markets are not democracies. To understand the difference I’ll recount a lesson I was taught as a trader trainee back in 2000.
It was explained:
If you poll the population, “Did humans walk the earth at the same time as dinosaurs?”, the responses come back split about 50/50. That’s democracy.
Now imagine there is a contract that trades openly on an exchange that is worth $100 if it is true that dinosaurs and humans co-existed and $0 if that is false. Even though the population is split, this contract is not going to trade for $50. It’s going to zero. Why? Because the small percentage of people and scientists who know the truth are going to see a profit from selling this contract even down to $1 since they know this proposition is false. And if the scientists don’t have enough money, they will be able to convince or get hired by people with more money to back this venture of selling this contract to zero.
That is the value of markets. You get correct answers. While a democratic poll may tell you what people believe or desire, it does not assign the proper truth value to the proposition. Now consider the implications of being correct. You make more money which gives you more resources to continue being more correct. The marginal price in markets is set by the market participants with the most money and as a group, they have the best-calibrated assessment of what fair value is. And these groups are in the minority of the total betting population. Markets are not a democracy.
<aside> 💡 Markets Are Not Democracies
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The “red queen” is a reference to Lewis Carroll’s Through The Looking Glass. Alice had to run increasingly faster to keep pace with the queen. The feeling that you need to continuously increase your effort to maintain your relative position is a fitting metaphor for market competition.
In The Commoditization of Information, Geoff Yamane argues that an essential element of many businesses including investment management is a form of information arbitrage. Historically, information moved slowly, enabling savvy investors not only to find and synthesize the information but build a meaningful position to take advantage of it.
The internet massively accelerated the speed of dissemination and distribution of information, reducing the ability to extract economic rents from hoarded information.
The internet massively accelerated the speed of dissemination and distribution of information, reducing the ability to extract economic rents from hoarded information.
<aside> 💡 Many investors don't even need research to benefit from this informational efficiency: active management fees effectively subsidize passive investment products by ensuring information in stock markets is mostly well-priced.
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Academics will argue EMH ("efficient market hypothesis") with fanaticism. The sects are known as "strong form", "weak form", and the hardly-crusade-inspiring denomination "semi-strong". This is hardly the place for that discussion.