Articles

The Power of Markets from the Perspective of a Pencil

In the age of iPhones and other technological marvels, it is easy to overlook the marvels of more mundane products. Such is the case with a simple lead pencil. The story of the pencil is a reminder of the creative possibilities of collective human efforts; it also illustrates an important lesson for investors.

Nearly sixty years ago, an economist published a short essay “I, Pencil,” in which a pencil narrates the story of its creation, describing the wondrous complexity and the intricate cooperative efforts behind the creation of the ordinary pencil. The full essay, “I, Pencil: My Family Tree as Told to Leonard E. Read,” published in 1958, can be found at: econlib.org/library/Essays/rePncl1.html.

A pencil has not much to it by appearance: some wood, lacquer, printed labeling, graphite lead, a bit of metal, and an eraser. Sounds simple, yet the pencil rightly claims, “Not a single person on the face of the earth knows how to make me.”

The narrative begins by recounting just a few of its “innumerable antecedents.” The story starts with a single tree that needs to be logged. It proceeds to consider all of the equipment used to harvest the wood – the saws, ropes, assorted machinery, and vehicles, all of which also have their own backstory about their fabrication.

Once at a mill, the logs are cut, kiln dried, tinted and waxed in a series of steps that require the skillful application of other materials and tools simply to create “small, pencil-like slats less than one-fourth of an inch in thickness.”

From the mill, loads of small wooden slats are transported to a factory, itself a marvel of accumulated capital. Here the slats are the retooled with cuts and grooves making them ready to receive a sliver of lead. The lead is actually graphite, a material that must be mined, transported, mixed with clay, chemicals and animal fats, baked for hours at a very high-temperature, and then treated further to ensure the strength of the lead and its ability to write smoothly.

Now beginning to look like a pencil, it receives six coats of lacquer to dress it up and is labeled using a heated mixture of carbon black resins. The pencil is topped with a brass piece that itself must be fabricated and affixed to the pencil. The pencil is finished with a rubber eraser that is made by reacting seed oil from the Dutch Indies with sulfur chloride and then adding numerous vulcanizing and accelerating agents. At least, that is how it was done in 1958.

The ordinary pencil is not so simple after all. “I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies – millions of tiny know-hows configuring naturally and spontaneously in response to human necessity and desire and in the absence of any human master-minding!”

The story of the pencil is about the power of markets to focus the collective creative energies of thousands upon thousands of individual participants and to produce an outcome that no single person could achieve. Each participant contributes “a tiny bit of know-how” and market prices are determined by the combined knowledge of all the participants.

Similarly, the financial markets reflect a collective knowledge that exceeds the knowledge of any single person. The financial markets reflect the collective judgment of its millions of participants, allocating resources and setting prices through their coordinated actions. But no one person knows what the market knows.

Some investment strategies try to outguess the market. Occasionally they work, but most often they do not. Over the long-term, it is very difficult to outperform the market because the market collectively is smarter than any single person. Occasional superstars like Warren Buffet seem to suggest otherwise, but even Buffet has openly acknowledged that for most investors there is little point in trying to fight the market.

If only someone would come up with an investment strategy that, instead of trying to outguess and outperform the market, simply aims to harness the collective wisdom of market prices by capturing broad market returns at a low cost.

 

This article appeared in the December 21st, 2017 issue of The Daily Record. Download a PDF copy.