Have heard this from your broker or advisor? “The stock market is a discounting mechanism.” “That’s factored into the price.” “Investors know about that risk, so it is in the price.”
I have been guilty of this myself in the past, but it is a poor use of language. It can misguide and confuse those who aren’t deeply familiar with financial markets. It is of course true that financial markets are a discounting mechanism, but asset prices only discount the risk of future events. They never fully discount the event until it happens. So if your broker tells you some future event is discounted in the market, he only means that the risk of that future event occurring is discounted.
Let me give you an example. Let’s say that there is a 1% probability of a pandemic wiping out half of the U.S. population. If such a scenario were to occur we can safely assume that the stock market would tank—let’s say by 90% for the sake of this example. If a pandemic doesn’t hit, let’s assume that the stock market will rise by 10%.
So we have a 99% probability of the stock market rising 10% and a 1% probability of it falling 90%. So far so good? Before we learned about these two possible outcomes our favorite stock market ETF was trading at $100. What should we pay for it now that we know about the risk of a pandemic?
Let’s assume we desire a 10% return in order to invest. With a 1% probability of the ETF’s price falling to $10 and a 99% probability of it rising to $110, the expected value of the ETF in one year is $109 [the math goes: (.01 * $10) + (.99 * $110) = $109]. In order to earn our desired 10% return we can pay the discounted price of $99.09 (down from the original $100) for the ETF—which would discount the risk of a pandemic.
So your broker might tell you that a pandemic is priced in because the stock market ETF you want to buy is down 0.91%. No need to worry, right?
Except if the pandemic hits, your $99 ETF will fall another 89%. While this is an extreme example, the same concept can be applied to your own investment strategy. Think through the possible outcomes for the securities you are buying, and what kind of returns could be expected in each scenario. Don’t just assume the most probable outcome is the outcome that will occur and that since the adverse outcomes are known and priced into the security the risk of loss is minimal. That may not be the case.
Jeremy Jones, CFA
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