What the Price of a Pencil Tells Us About the Market

A sharpened pencil“I, Pencil: My Family Tree as Told to Leonard E. Read” is an essay published in 1958 by the same Leonard Read.

In it, Read tells the story of a pencil, from tree to finished product, from the perspective of the beloved writing utensil. The idea behind the essay is that no individual has the means or knowledge needed to make a pencil by themselves.

The common pencil – along with the ability to buy one for next to nothing – is the product of a remarkable combination of information, market participation, and market prices.

How Important Is Price?

When we look at a pencil, we might be tempted to think it’s a product of a single person’s efforts. It’s composed of pretty common materials like wood, graphite, paint, metal and rubber.

But take a closer look at how each part is manufactured, and you’ll see that putting them together is a pretty complex process.

The wood is a perfect example: To produce wood you need a saw, and the saw is made of steel. Stell requires iron, which has to be mined, go through the smelting process, and molded.

Some kind of transportation is needed to move the wood from the forest to a factory where machines will process it into lumber, which is then transported to a different factory where other machines assemble the various parts into pencils.

Every part needed to create a single pencil has a similar story. Materials are gathered from remote places and refined through a series of processes.

What’s even more impressive than the process of creating a single pencil is the activity of millions of people across the globe that is needed to complete the entire process. Farmers, loggers, miners, and factory workers, along with the help of countless indirect contributors like railroad makers and ship-makers.

These efforts are all brought together by market prices. They allow this enormous operation to move efficiently.

Armed with specialized knowledge about their costs, constraints, and effort, workers use market prices to utilize what others know, in order to make choices about how to direct their personal resources and make ends meet.

Consider the relation between a farmer, a logger, and the price of a single tree.

The farmer knows very well the costs, constraints, and effort involved in growing trees. He’ll look for the highest price to sell to a logger, in order to increase profit. The logger will of course be looking to pay the lowest price to increase his own profit when he turns around to sell the wood to a factory, looking for the highest price.

A contract between a farmer and a logger exists on the basis of an agreed price, which reflects their shared knowledge of the costs and constraints involved in growing and harvesting trees. That same knowledge puts them in a position to choose how to best place their resources in order to be profitable.

The agreed price is what ultimately makes that coordination possible.

On a larger scale, competition between several loggers and farmers facilitates the formation of prices. Others see the market price and use it elsewhere along the production chain (like the lumber factory, for example) to determine how much they should expect to pay for wood, and to plan accordingly.

The Power Financial Markets Hold

This whole process is analogous to how financial markets work. Generally speaking, markets do a pretty great job of distributing resources, and they allocate one resource in particular: finance capital.

Millions of individuals participate in financial markets, and each one chooses to buy and sell securities all across the globe according to their personal needs and desires. Every day, millions of trades are made, and the collective knowledge of every participant is combined to set security prices.

Exhibit 1 shows the enormous amount of participation that takes place in world equity markets on a given day in 2015.

Exhibit 1: Embrace Market Pricing

world-equity-trading-in-2015

In US dollars. Global electronic order book (largest 60 exchanges). Source: World Federation of Exchanges.

If we apply Read’s allegory here, trying to outguess the market is like trying to make your own pencil from scratch instead of buying one from the store and benefiting from the efforts already applied there. Anybody who tries to outguess the market is up against the combined knowledge and experience of every buyer and seller involved.

At the end of the day, it is severely difficult and expensive – not to mention pretty much impossible – to try to outguess the market, and over time a market-based approach is almost certain to render better results. It’s easy to find data that demonstrates this.

Exhibit 2 shows us that only 17% of US equity mutual funds survived and surpassed their goals over a fifteen-year period.

Exhibit 2: Don’t Try to Outguess the Market

us-equity-mutual-fund-performance

Beginning sample includes funds as of the beginning of the 15-year period ending December 31, 2015. Past performance is no guarantee of future results. Source: Dimensional Fund Advisors, “The US Mutual Fund Landscape.” See disclosures for more information.

What We Can Learn From A Pencil

Leonard Read’s story has a lot to teach us about how prices are formed, what kind of information they contain, and how they’re used. No one person could take a tree trunk and turn it into a pencil, but combined human effort gets it done every day.

At the end of it all, market power is a benefit to everyone. It’s the reason we can turn time into money and earn a profit from a simple pencil.

The lesson for investors is this: rather than trying to fight the market, utilize a strategy that capitalizes on the power of market prices. Harnessing this power can unlock the rewards the markets offer capitol providers.

For more on harnessing the market’s power, check out our ebook Making the Markets Work for You



 

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