In Chapter III of The Theory of Political Economy, William Jevons describes the economic notion of marginal value in 1871.
Nor, when we consider the matter closely, can we say that all portions of the same commodity possess equal utility. Water, for instance, may be roughly described as the most useful of all substances. A quart of water per day has the high utility of saving a person from dying in a most distressing manner. Several gallons a day may possess much utility for such purposes as cooking and washing; but after an adequate supply is secured for these uses, any additional quantity is a matter of comparative indifference. All that we can say, then, is, that water, up to a certain quantity, is indispensable; that further quantities will have various degrees of utility; but that beyond a certain quantity the utility sinks gradually to zero; it may even become negative, that is to say, further supplies of the same substance may become inconvenient and hurtful…
The final degree of utility is that function upon which the Theory of Economics will be found to turn. Economists, generally speaking, have failed to discriminate between this function and the total utility, and from this confusion has arisen much perplexity. Many commodities which are most useful to us are esteemed and desired but little. We cannot live without water, and yet in ordinary circumstances we set no value on it. Why is this? Simply because we usually have so much of it that its final degree of utility is reduced nearly to zero.
Examples of the margin setting the price are all around us. The price of power is set by the last unit of demand, which necessitates the use of “peakers” or generation with the most expensive fuel inputs. The most optimistic bidder sets the price in a classic auction.
Heck, just imagine a neighborhood where everyone had to recertify the price of their home by being willing to pay the current market value. I live in CA. Most people living here would not and could not pay the current marginal price to live here. That many of those same won’t sell is not irrational; it’s called making a wide market. You can drive a truck through their bid/ask, but so what? The point is that marginal utility is setting the price, not the average. It makes sense. Real estate is an auction.
The idea that the margin sets the price is obvious when it’s pointed out. But it’s also obvious that people haven’t internalized it.
[This is an example of a general phenomenon in which deriving an answer is much harder than verifying whether it is correct. It’s harder to compute the cube root of 729 than to verify that 5 is wrong or 9 is right. This is the same principle behind crypto mining. It’s computationally expensive to find a specific nonce, but easy to confirm whether a solution satisfies the requirements.]
Your uncle, your cousin, your brother-in-law will, with a straight face, tell you they know more about a stock than the average person as if the average person’s opinion matters when it comes to making money. The consensus price is set by well-resourced, well-connected wiseguys. If you can beat them, you’re rich. If you can do it reliably and on large sums, you’re on your way to becoming one of them, but the standard for feeling like a winner at trading is nothing short of being able to consistently beat the marginal price. It’s your record against the spread.
Marginal thinking blind spot
People often take up my offer for paid calls because they want to bounce a pitch off me. They want a sparring partner, criticism, feedback, and tips. Nobody would say they were trying to persuade me, but it’s only human to assume that they would feel greatly encouraged if they did. But the best-case scenario on that front is a stalemate. The shape of everything that works, at least in public markets trading, is nuanced and requires handling many details at a high level. There’s no magic bean machine where someone is gonna make me say “take all my money”.
[If the idea is a massive layup, it’s resting on a special, likely fleeting access. I’d even shove high-barrier-to-entry infrastructure in this category even if the details vary. In all these cases, the provider of the strategy has a bargaining position that makes it a layup for them but not the capital provider whose results will be haircutted by the cost of the bargain.]
Many arriving with a pitch aren’t even getting to the stalemate. They are confusing their extensive knowledge, knowledge far better than average, with sufficient-to-be-competitive knowledge. To be able to trade, they must have a strong concept of marginal price, yet there’s a blind spot when the concept is applied to themselves.
You can’t go wrong by drilling the concept of value over replacement into your brain. It should be part of your mental OS to apply that lens to all of your major decisions. If you think of replacement value as a strike price, VOR prompts you to think of the moneyness of the strike and the possible upside above it. It goes hand-in-hand with the economic concept of opportunity cost as the strike of a put you’re giving up.
Ask yourself
Back to markets for a moment.
2 key questions to ask yourself:
Can the sharpest players here warehouse this entire risk?
If so, the price already reflects their view, and you have to beat them to make money.
If not, is it because they don’t know about it (maybe it’s very small capacity, but even then, you could reframe as “the sharpest players who would know about this”). Or maybe, it’s just because there’s a general “wrong way” risk premium. SP500 puts are overpriced since there’s no hedge to the economy actually imploding. All such hedges, at the limit, are constrained by general credit and solvency, making a short SP500 put trade an ever-present and therefore uninteresting trade, just as being long passive indices is underwriting an ever-present risk premia (notwithstanding any comparisons with implied forward returns with real “risk-free” rates).
Are you on par with the sharpest players who are setting the price?
This second question is a prompt to think strategically about your role in the system, not an invitation to consider your IQ (which in the range-restricted sample of “competitive investors” is uncorrelated with performance and perhaps even anti-correlated in a Berkson Paradox-style inversion). The prompt should make you consider who competes at your chosen horizon, what constraints you have versus them, and how incentives shape both the chosen horizon and constraints.
Finally, a meta-consideration that sits above these questions.
Notice how comparative trading is. It is inextricable from VOR, competition, and the zero-sumness of alpha.
The entire decision to care about this is a container that all your thoughts will need to live in. This isn’t to say that trading is uniquely competitive, but like sport it’s defined by it. Life is always competition in some abstract sense, but in trading you’re a crab in a bucket. An artist competes by being N of 1 and achieves that by competing with themselves. I’m not saying this is easier or harder, I have no such authority on which to even speculate, but it is different.
I’ll stop well short of lionizing infinite games over finite ones. We have both and I’d rather people just fit where they flourish rather than serve some high-minded ideal (the statement of “I’d rather” is itself some high-minded ideal, but I have no idea how to hit ctrl-break on the recursion so take it easy on me). I only make the distinction between game types in case it strikes a chord for someone debating what to focus on.