My family and I recently traveled to Columbus, Ohio with my father-law and sister-in-law to help celebrate his seventy-sixth birthday by attending a football game at his alma matter, The Ohio State University.
We had a great time at the game, seeing the school and getting into the school spirit while we were there. On the return flight (which was delayed by a fuel truck stalled right behind our plane), we were notified by airline personnel of an all too familiar problem that the flight was overbooked. They were looking for volunteers to come forward who would be willing to travel on the next available flight in exchange for money (and a free hotel stay). The initial offer was $500 which was subsequently increased to $700, then $900 and finally $1,000 before they were able to find a passenger that would give up their seat.
What immediately came to my mind is how similar that process is to how the stock market works.
The $1,000 amount the airline paid to the passenger was the price at which one passenger was willing to trade their seat for money. It was the clearing price.
This is essentially how prices are set in the stock market. A stock’s clearing price is the price we see where market participants are willing to trade.
And so, what are some key takeaways from thinking about stock prices this way? One important takeaway is putting in context what active managers (i.e. stock picking mutual and hedge fund managers) imply about clearing pricing based on their activities. A stock picker is saying that the price of a stock is “wrong” based on their estimates of future earnings or some other metric (it’s either too high or too low) and they can beat the market by buying shares that are priced too low or selling shares that are priced too high. But the overbooked flight concept puts market prices in a different light. The clearing price cannot be “wrong” because it is exactly the price that clears the market at that point in time.
How has it worked out for stock picking managers who act as if market clearing prices are wrong?
According to a study from Dimensional Fund Advisors “The Fund Landscape 2024”, over the twenty years ending December 31, 2023, 18% of equity mutual funds survived and outperformed their benchmark (82% either closed or underperformed). Among active fixed income mutual funds the results were even worse. Over the twenty years ending December 31, 2023, 15% survived and outperformed their benchmark (85% either closed or underperformed).
Avoiding active managers is a simple choice to use low-cost index and index-like funds and ETFs. Whether you are flying or investing, going with the flow and patience are the best approach to help you get to where you want to go.