If You Don’t Understand Markets… You Don’t Know Sh*t
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We live in a mad world of money markets.
There are stock markets, crypto markets, real estate, gold, sneaker and Pokémon card markets.
Yes, there’s even a creepy little market for Britney Spears hair!
“A market” is simply a collective meeting of buyers and sellers for the purpose of engaging in some form of trade through the exchange of money.
Buyers and sellers come to meet and agree on a price, trades are made and the market continues to move along a price trend.
It doesn’t matter what market you are looking at: all markets and market prices follow the same fundamental principles.
And these principles will either end up working for you or against you!
If you want to avoid making deadly decisions with your money and start approaching the murky world of finance with a little more wisdom and awareness, there are a few truths you need to understand about the underlying nature of markets, their participants and the forces that drive market prices.
So, whether it’s stocks, stones or sneakers, what drives the price of anything to rise and fall over time?
Economics 101
Sorry, I know you didn’t come here for a boring school lecture.
But it’s essential for your success as a trader or investor not to allow your thoughts and actions to be controlled from within a market.
Instead, you must step back from the apparent chaos and confusion of the markets and their moving prices, see the bigger picture and understand the basic forces at work.
So how do markets function?
As you are seeing on the surface, markets are simply measured by their trading prices over time. As buyers and sellers continue to meet and trade at agreed prices, markets track these trades and trend these movements.
But what drives the constant change in price?
Market prices move according to the basic economic principles of “supply and demand”.
Markets rise and fall due to the relative level of supply from sellers and demand from buyers in response to current price.
If we assume that all other market factors are fixed, an increasing number of buyers (demand) relative to the number of sellers (supply) will push prices up.
Likewise, increase the weight of sellers (supply) relative to buyers (demand) and prices will go down.
When buyers outweigh sellers in a market, buyers must be willing to pay a higher price to get their hands on what is being sold in limited supply. With high demand and low supply, sellers also expect to receive a higher price… and market prices will rise.
Now, this is where today’s markets go a little nuts.
According to simple economics, as the price climbs higher what effect should this have on a market?
Naturally, the higher the price the more likely we are to sell and the less likely we are to buy. Or, in economic terms, an increasing price causes an increase in supply and decrease in demand.
The rising price trend then slows down in response to this shifting balance between market supply and demand.
A high price will often re-shift the market’s balance in the other direction. As the number of sellers — looking to cash in on a sudden jump in price — outweigh the number of eager buyers, sellers must accept lower prices… and the market will drop.
This delicate balance between market supply and market demand is what causes all market prices to rise and fall over time: stocks, bitcoin, even scalped tickets to the N’Sync vs Backstreet Boys Battle!
But you already knew all this from high school, right?
A Market is Not a Price
In theory, why does a changing market price cause such a direct shift in the balance of market demand and supply?
The golden rule of money comes from the legendary investor, Warren Buffett:
“Price is what you pay, Value is what you get”
The simple objective of any smart buyer is to pay the lowest price to get the most value. And likewise, smart sellers are trying to gain the biggest reward by selling the least amount of value at the highest price.
Buying a Malibu mansion for $10,000 is a very smart move.
Buying J-Lo’s half-eaten, Salmon bagel for $1000 is certainly not.
Is it price alone that dictates this judgement? Not one bit.
It all comes down to one underlying question: what real value are we getting for our money?
How are “price” and “value” balanced?
In today’s world it’s easy for people to become totally fixated on market prices alone. With a phone in hand providing constant price updates and an impulsive urge to simply “buy low, sell high”, price is all that the average buyer sees.
Realize that money markets only give you half the picture. They cannot tell you the real value of a new coin or trendy investment: they can only tell you the price.
Remember, price is what you pay but value is what you get.
So, what is value?
Value is what you really get outside of the market.
Consider investing into a company like Amazon. Amazon is a real company: it has real warehouses, real inventory, real intellectual property and various other assets — of which, as a shareholder-owner, you own in part.
It has a global reputation, strategic position and infrastructure that allows it to sell real goods and generate real profits — of which, as a shareholder-owner, you are entitled to in part.
This is Amazon’s real value.
It has nothing to do with the market. It has nothing to do with the price.
But if markets and the returns they give us are purely based on price alone, what role does real value play?
Think of value like a market’s gravitational field. No matter how much propulsion market prices have — either upwards through collective feelings of optimism, impatience and greed, or downwards through collective feelings of pessimism, fear and panic — all market prices ultimately pull towards an asset’s real value.
Real value is what must dictate the price buyers will pay for an asset. Sooner or later, all markets and their people must come to understand what “value” really means… and market prices will reflect accordingly.
Sooner or later, price equals value.
So, what’s the real value of your friend’s latest, little money craze? When they start telling you about price, kindly let them know they don’t know sh*t…
Forget It, Markets are Mad
Although classic economics tells us that people always make logical and objective decisions, in reality the money markets are heavily influenced by mass monkey instincts: collective feelings of optimism and pessimism, greed, desperation and fear, group think behavior, imperfect information and natural bias.
Amongst the chaos and confusion of these current times, most people are far from the simple, rational folks that reside in our disco-era economics textbooks.
In a time where the alert masses are so deeply tuned in and connected, the collective impact of basic human influence has never been more apparent than in today’s financial world.
The money markets are not really a collective set of random, independent opinions and actions, but a synchronized flow of the human condition: sharing common thoughts and feelings in response to the same information and influences over time.
We are all attached to the latest events and headlines, no matter how impulsive or irrelevant they may be. No one is impervious to widespread, social trends and outside influences. Therefore, mainstream hype and shifts have a major impact on how individuals collectively behave and drive market prices over time.
Benjamin Graham, the godfather of value investing, coined the term “Mr. Market” to describe the human, bi-polar nature of markets. As a highly experienced investor, he continued to witness market prices jumping and dropping significantly from one passing moment to the next — often with little connection to the real value of what was being traded.
It’s only human nature to over-react in times of opportunity when prices are rising… only to turn around and over-react when times are bad and prices start falling.
“The more things change, the more they stay the same” — Alphonse Karr
Today, technology is just a formality. It does not change the underlying nature of markets and people. The simple human condition, coupled with instant access to the same information and money markets, is a major force behind the momentum of market prices today.
Following a Crowd of Followers
By nature, human beings are drawn to groups with shared ideas and beliefs.
Therefore, the average human, with high hopes and dreams, is far more likely to follow and perpetuate rising market trends than to step out and avoid them.
These days, it’s very easy for any ordinary kid or adult to invest in stocks, crypto and NFT markets. But what does your “Average Joe” really know about markets and the underlying value of these complex assets?
Herd instinct is a market phenomenon where investors choose to follow what they believe others are doing rather than stepping back, thinking for themselves and drawing their own objective opinions. In other words, investors with herd instincts will follow trends based almost solely on the fact that others have been doing the same!
And what did those others base their ideas and decisions on?
The fear of missing out on a profitable opportunity is often the driving force behind herd instinct, which only fuels market demand and causes prices to rise even further!
Basic economics tells us that, under controlled conditions, rising prices must cause market demand to fall.
However, in a market of herd buyers who see only price, an increasing price can often cause increasing demand!
Forget about any clear sense of “value for money” — herd buyers see prices rising, and so, feel more encouraged to buy as the price climbs higher.
And your old, college Economics professor is left scratching his big shiny head.
But of course, these irrational instincts and their effect on market prices must go both ways.
And they do.
Poppin’ Bubbles
At times, markets get stupidly excited.
When all the shiny stars of a financial opportunity start to align, market behavior can start to lack any basis of real value, and instead be driven by impulsive human emotions, such as optimism, impatience and greed.
A “bubble” occurs when an overly-excited market drives up the price of an asset far beyond its real, long-term value.
When a market starts blindly believing that rising prices in the past are an indication of rising prices in the future, naturally buyers become over-confident and greedy. Basic human impulses take over a market, as buyers forget to act with any clear sense of awareness and caution.
They fail to respect Warren Buffett’s timeless wisdom: price is what you pay, value is what you get.
Now the market is being controlled by only one fear — the fear of missing out!
At times, money markets inflate and float off to price levels far beyond the real value of the assets being traded. Rising prices continue to hypnotize buyers into paying ever-higher prices — giving them the optimism and expectation that they can sell at an even higher price in the future.
As market demand continues to fuel market demand, a positive feedback loop is created and market prices keep climbing.
But does optimism and excitement last forever?
Do the times never change?
Well, let’s ask the man who invested his life savings into Beanie Babies…
With time always comes change.
As past momentum loses steam and media shifts our attention, excitement in a market can soon fade. As investors lose their desire to feed the high price level, market demand drops. Now, the market suddenly regains its rational senses and the bubble begins to burst.
With momentum shifting and market physics starting to take effect, the once-excited mood of the market turns sour… quickly.
And now, these over-priced assets are a major liability!
No demand…high supply…sell, sell, sell…and you know where prices go.
Think of the “Dot.com” bubble around the turn of the new millennium: where the stock market became far too excited about the next high-tech, space-age internet companies like “CDNow.com” and “Pets.com”.
As excitement and irrational optimism about the future of internet stocks swept over the market, buyers soon forgot the true meaning of “value” — and paid a severe cost.
Beanie Babies, crypto, stocks or sneakers… all markets follow the same principles of economics and patterns of human behavior.
Never forget, all money markets and their underlying assets have a real value that has nothing to do with price.
Nothing.
Forget about price: what is the real value of an asset?
This simple state of awareness is what separates the smart buyers from the blind gamblers.
Sooner or later, every asset reveals its true value.
Sooner or later, every blind gambler is exposed.
So, through the confusion and craziness of today’s world, just know that all money markets follow the same, basic principles of supply and demand, the inescapable market physics of Price = Value, and these famous last words:
“Only two things are infinite: the universe and human stupidity” -Albert Einstein
