A reader asks:
“[At the recent Bogleheads event], Vanguard economist Roger Aliaga-Díaz spoke about a number of trends occurring in various parts of the world — things like the slowing of China’s economic growth rate. When asked what we should do with our portfolios because of these trends, he kept saying that all the trends are already ‘priced in.’ What specifically does that mean?”
At any given time, the price of a stock reflects the market’s consensus expectations about the company’s future earnings.
For example, if the market expects Google to have rapid earnings growth going forward, then Google shares will be expensive relative to companies with lower expected future earnings (i.e., Google will have a higher price-to-earnings ratio). One would say that the market’s expectations about Google’s earnings growth are “priced in” — that is, they’re already built into the price.
This is a key point for investors to understand because it means that buying shares of Google stock will only provide you with above-average returns if the company’s earnings grow faster than expected. If the company’s earnings grow quickly, but no more quickly than the market expected them to, the stock’s performance will not be any better than the performance of the rest of the market (and will probably be worse).
In other words, the performance of a given stock is not determined by whether the underlying company performs well or poorly. Rather, it is determined by whether the underlying company does better or worse than the market expected it to do. There is, therefore, little to be gained from picking individual stocks unless you know something that the rest of the market doesn’t — something that isn’t already “priced in.”
And the same thing is true at larger levels. The collective price of the stocks that make up a given industry or country reflect the market’s consensus about expectations in that industry or country. So there is little point in moving your allocation between countries or industries unless you know something that the market doesn’t about those countries/industries.