When contemplating a potential investment, how can you know if it is fairly priced? Such a determination is critically important since even the best company will prove a poor investment if its stock is purchased too dear. Paying a fair price for an investment vehicle is just as important as not overpaying for a house, a car, or anything else you might exchange for your money.
Generally, we have confidence in the pricing of investments because they are traded on a highly liquid and properly functioning market. In other words, a great assembly of buyers and sellers is constantly trading in their own self-interest so as to ensure equilibrium pricing. If the price falls too low, buyers swoop in to pick up the “bargain.” By the same token, if the price rises too high then buyers become scarce while short-sellers push the price down to capture a profit. Economists are secure in the belief that, if the marketplace is honest and characterized by free flow of information, the result is pricing that takes into account all known information. You can have confidence in such markets, too.
Such well functioning markets allow us to buy and sell with some assurance that we are not being taken advantage of, ripped off, or cheated. What happens, though, when we invest in vehicles that do not “trade” on such markets and, so, are not subject to such a pricing mechanism? You can almost guess the answer.
Any investment you make is being sold to you by someone else. Just like you, the other side is hoping to get the most favorable pricing possible. While you hope to “buy low,” the other person is seeking to “sell high” – to you! Do you suppose their desire to make money from you is tempered by some innate sense of “fairness” that will stop them from pricing too high? Probably not. In fact, they probably think fairness is defined as “whatever the market will bear.” In most cases, they will raise the price you must pay to the very highest level they can get away with.
In the absence of a market pricing, you have a big problem. Most financial practitioners know so much more than you do about the various investments and their proper prices. You know much less and are at a dangerous disadvantage. In all likelihood, they will price financial products in such a way as to claim almost all surplus value for themselves. As a result, it will be very hard to achieve a fair rate of return on such investments.
What kinds of investments do not trade on proper markets and so are subject to the dangers of being unfairly priced? There have long been many such financial products and their names change regularly. A partial list, though, would include hedge funds, private equity, “non-traded REITS,” so-called “alternative investments,” and a variety of annuity products. The chances of investing in any of these at a truly “fair” price are slim.
The problem and the solution are plain to see. You should avoid investing in anything that does not trade on a well regulated and properly functioning market. Most stocks trade on such markets. So do many bonds. Big liquid ETFs are traded throughout the day. And most mutual funds, while not traded directly, are made up of a portfolio of such investments and are priced daily in light of the market prices of their holdings. Such vehicles offer you the relative safety of market-based pricing. Just say “no” to any of the alternatives that fail to meet this standard.
In doing so, you ensure the likelihood of paying a fair price for your investment. And fairly-priced investments dramatically increase your chances of success.