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Chapter 13. Follow the Experts > Theoretical Roots: The Value of Expert Opinion

Theoretical Roots: The Value of Expert Opinion

To understand how and why experts may be able to beat the market, you have to begin by examining the process by which market prices are set. While market prices are set by demand and supply, the market price of an asset is an estimate of its value. Investors in the market assess the value according to their expectations for the future. They form these expectations by using the information that is available to them, and this information can arrive in different forms. It can be information about the past price performance of the asset, public information available in annual reports or filings with the SEC, or information available to one or a few investors.

While the steps in this process—receive information, process the information to form expectations and trade on the asset—may be the same for all investors, there are wide variations across investors in how much information they have available and how they process the information. Some investors have access to more information than others. For instance, an equity research analyst whose job it is to evaluate Cisco as an investment will have access to more information about the firm than will a small investor making the same decision. These differences in information are compounded by the different ways in which investors use the information to form expectations. Some investors build complex quantitative models, converting the information into expected earnings and cash flows, and assign value to stocks. Other investors use the same information to make comparisons across stocks. The net effect is that, at any point, investors will disagree on how much an asset is worth. Those who think that it is worth more will be the buyers of the asset, and those who think it is worth less will sell the asset. The market price represents the price at which the market clears, that is when demand (buying) is equal to supply (selling).


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