Seek lower cost options when investing in the market
October 30, 2014
There are several factors you will want to consider when buying a stock: what to buy, what price to pay and how to complete the transaction.
The ultimate goal of making money will be influenced by the decisions you make when buying shares of a company.
Investing in a stock starts with deciding how much that stock is worth and therefore what you are willing to pay.
The value of a company is based on the expected cash flows. If a company has higher expected cash flow then it will have a higher price relative to other firms.
A stock is only worth what an investor will pay for its shares. The investor has lots of options and competitive market forces help keep the price of that stock fair.
An investor may purchase other stocks or shift their funds to other investment classes such as real estate or bonds. As stated above there are a lot of options.
So, who actually determines the ultimate price of a stock? The market does. And that market consists of millions of people.
Globally, people are buying and selling investments on a daily basis. It is the sum of all economic activity that determines the market price of a stock.
This is in part because of how liquid the investment world is. Money flows freely so market participants including buyers and sellers vote with their cheque book on what they are prepared to buy or sell, and at what price.
The market is in some sense everyone; millions of investors directly or indirectly affect the price of a stock.
You have two options when determining how to buy stocks. You can purchase them directly or you can choose a professional such as a mutual fund manager to make those buy and sell decisions for you.
Investors want to maximize their profit and often want to “beat the market.” Most rely on a professional manager but with all of their expertise do they actually add value and beat the market? Not according to the results.
The reason professional managers do not add value to the investment process is that the stock market is extremely efficient at determining the value of stocks.
These managers also come at a fairly high cost. The business model of the investment manager is not one that adds value to an extremely efficient investment market. Their management costs are high and not economically justified.
In 2012 Eugene Fama said that only three per cent of U.S. mutual funds with at least 10 years of results, managed to cover their costs. He has been arguing since the 1960s that markets are efficient. In 2013 he received the Nobel Prize for his work in this area.
We recommend you use this information to your advantage. The value of stocks is determined by expectations of future cash flow. The market is efficient at determining the value of a stock and expensive managers do not add value.
If you are investing, then seek out low cost options that give you market investments. Do not spend money on managers who attempt to outsmart the market when history proves their high management costs are not economically justified.