Interesting article on the Wisdom of the Investing Crowd

[Brendan Burgess]

Rory Gillen has an interesting article here

[broken link removed]

The rough argument is that the current value of the stockmarket, being the average of the crowd, is the right value or best estimate of what is to come.

I would probably have agreed with this some time ago. I would have believed that one can't time the market.

However, I am not as confident in this view any longer. Most of the time it is true. But, from time to time, the market is in a bubble and it's identifiable at the time. Having said that, the only bubble I identified at the time was the dot.com bubble.

When Shiller was shouting about Irrational Exuberance and that the general stockmarket was way overvalued , I preferrred the arguments in Siegel's Stocks for the Long Term. Now, I don't know who was right.

Brendan

 

[dub_nerd]

I believe there's one huge difference between the market and guessing how many jellybeans in the jar: feedback sensitivity! The averaging effect depends on each of the guesses being independent. The market is nothing at all like that. The participants look at what the other participants are doing, and act accordingly. Feedback is the essential component of every chaotic dynamical system.

If the market was volatile without being chaotic then it would be easy to make money by just analysing the trends. Even a stochastic system may be analysed. But a chaotic system gives the misleading illusion of having trends. It's swings occur unpredictably on all timescales and all size scales. "Past performance is not a guide to future performance" -- it's not just a dire warning to investors, it's the hallmark of chaotic systems of every type.

For some decades now, many have believed that markets revert to some long term mean. That would make long term investing (in pensions etc.) a safe bet, even if short term endeavours like day trading were only for the foolhardy. But it's questionable as to whether even this is true, as many have discovered with pensions that have stagnated or fallen over time periods equal to significant portions of a working life. Elizabeth Warren, Harvard professor and US Senator, and a child of Depression era parents, says that it was only around 1970 that people started believing in such investments again, after the generational memory of the crash of '29 faded.

Just my tuppence worth...

 

[Brendan Burgess]

Hi dub nerd. Very interesting analysis.

I didn't think that the jellybeans was a good comparison either. There are few experts in jelly bean estimating , so my guess is as good or as bad as yours.

If you have been trained in company analysis and you have plenty of experience of it, your assessment of the value of a share should be better than the average punter. But then again, if the population of guessers is limited to the experienced analysts, maybe the jellybean estimating analogy, does apply.

The feedback point is valid. It would be interesting to do the Jellybean estimates where everyone in the room announces their estimate publicly and in turn.

 

[Marc]

I covered this story on my blog in 2011.

[broken link removed]

This is a classic argument and the uncertainty around the "right" answer has been summed up by awarding the Noble Prize in Economics to two apparently different views of the markets.

Gene Fama is the father of the Efficient Market Hypothesis which says that prices reflect all available information and therefore in a strict view of the theory, its basically impossible to beat the market because you are always paying a "fair" price.

However, nowhere in this theory does it say that the market price is the right price. It says that it is the best estimate of the right price. All prices could potentially be wrong. In fact, when tomorrows trades are placed and prices move we know for sure that today's prices were in fact "wrong" or the price would not move tomorrow.

Fama argues that you can't identify a bubble ahead of time and that;

“Irrational bubbles in stock prices are indistinguishable from rational time-varying expected returns.”
Eugene F. Fama. “Efficient Capital Markets: II Journal of Finance December 1991​

Bob Shiller says no, markets are prone to forming bubbles and that these are predictable.

When I'm lecturing this stuff, I describe markets as being like custard...bear with me.

Custard is a non-newtonian liquid. This means that it typically has many of the characteristics of a liquid -except when it doesn't.

Because it contains starch, if you apply pressure to custard it forms a solid and in the extreme you can walk on a swimming pool full of custard.

Seriously, watch this: https://www.youtube.com/watch?v=BN2D5y-AxIY

So, markets are like custard, most of the time they work pretty well, except when they don't, and just like custard, they tend to break down when they are under pressure.


What is the recommendation for investors in markets? They should operate as if they are efficient and both Fama and Shiller (and indeed Warren Buffett) would recommend that the best way to invest is through an index fund.

However, just because investors should operate as if markets are efficient doesn't mean that they are and that after the fact we will all know for sure if we got carried away with ourselves.

The real problem for an investor is to be sure beforehand that they are in the middle of a bubble and to get out.

“Market behavior often diverges from what we would expect in a rational efficient market, but these anomalies do not create such large profit opportunities that active fund managers as a group earn abnormal returns.”​

Richard H. Thaler, “The End of Behavioral Finance” Financial Analysts Journal November/December 1999​

"If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you are.”​

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"If you're picking somebody else to manage your money, the chances of finding a market-beating path are even harder.”

Justin Fox. The Myth of the rational Market Harper Collins, New York




“Markets are not so stupid. They’re actually quite efficient.”​

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“Most things are reasonably priced. It’s very difficult to outperform benchmarks.”​

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“Mispricings and Unrealistic Expectations” Dow Jones Asset Management March / April 1999​

 

[Gary]

Folly of crowds

dub_nerd is correct.

The common-sense view about the 'wisdom' of the crowd, makes a big assumption: that when people make decisions , they do so independently of one another. But people rarely make decisions independently.

It's dangerous to draw any firm conclusions from the jellybean example because the guesses were made by people independently - i.e. were not influenced by one another. The stock market is a large and complex interconnected system made up of the interactions of millions of individual investors. There is social influence - which makes it very hard to predict the outcome - so Rory is correct that individual predictions are useless.

In a fascinating study conducted by Princeton University on the influence of social behaviour, we get some insight into this. The study attempted to explain why experts routinely fail to predict which products will succeed. They investigated the role of social influence on the nature of success for music.
The Princeton study controlled for social influence by setting up separate groups. They did this by creating an artificial ‘‘music market’’ in which 14,341 participants downloaded previously unknown songs with one group having no knowledge of previous participants’ choices and other groups having access to this information. The results were fascinating.
“Increasing the strength of social influence increased both inequality and unpredictability of success.”
In the groups which had access to the choices made by others, success was also only partly determined by quality: “The best songs rarely did poorly, and the worst rarely did well, but any other result was possible.”
The implications of this for market efficiency, random walk etc are up for debate, but think these have been thoroughly debated elsewhere on this site.
I just think we need to be careful in drawing conclusions from many parts of the finance world, which make too many simplifying assumptions. I'd prefer to be approximately right, as opposed to precisely wrong.

 

[Jim2007]

My two favourites are still:

- Extraordinary Popular Delusions and the Madness of Crowds it is still as relevant today as when it was first published in 1841

- [broken link removed] from Tweedy Browne.

 

[cremeegg]

I am not sure what the "question" here is but I have two observations.

The social influence argument is weak, I can believe it may affect music choices, but most investing trends are driven by fundamentals, and if they go too far may turn to busts.

The Irish housing situation is a good example. In 1996 there were 1m people at work in Ireland, in 2006 there were 2m people at work. The demand for housing on a huge scale was real. If Lehmans had not been allowed to fail we might even have gotten away with the soft landing.

As for beating the market, well if you were the brightest kid in the class at school, maybe you could beat the market, if you were the dumbest, probably not. A little emotional detachment helps as well.

At the end of the day the most important issues is what type of money are you investing, and how much risk should you take on.

 

[dub_nerd]

...most investing trends are driven by fundamentals, and if they go too far may turn to busts...

Isn't that the point though? We do have regular busts. Assuming that "fundamentals" imply some sort of objective valuation, the busts must be driven by something else. And if the market en masse loses it's objectivity, it's seems fair to call it "the madness of crowds".

I definitely couldn't agree about our housing situation as an example. I believe our housing disaster was saved from being even worse by the Lehman's collapse. We went seemingly overnight from claims of house prices being fundamentally sound to having 300,000 empties. We're not now starting to demolish rural ghost estates because demand for accommodation has collapsed but because it was never there in the first place. There was plenty of demand for houses (as opposed to accommodation) as long as people thought prices would go up forever. We were building houses faster than Germany's reconstruction after WWII. I can't believe anyone would claim with the benefit of hindsight that we had a chance of a soft landing by 2006. Our collective behaviour was completely delusional, very much "the madness of crowds". Even now we have 160,000 people in the country owning four or more houses each.

It's a feature of chaotic systems that they return to some equilibrium after wild excursions away from it. It would be a brave person who would claim we're on a wild excursion away from a house price equilibrium struck in 2006. With due regard for the AAM ban on specific house price predictions, I think it's more likely that the equilibrium lies in the opposite direction, with the primary cause of our housing bubble -- cheap credit -- now fuelling a bubble in equities.

 

[Rory Gillen]

Rory Gillen has an interesting article here

[broken link removed]

The rough argument is that the current value of the stockmarket, being the average of the crowd, is the right value or best estimate of what is to come.

I would probably have agreed with this some time ago. I would have believed that one can't time the market.

However, I am not as confident in this view any longer. Most of the time it is true. But, from time to time, the market is in a bubble and it's identifiable at the time. Having said that, the only bubble I identified at the time was the dot.com bubble.

When Shiller was shouting about Irrational Exuberance and that the general stockmarket was way overvalued , I preferrred the arguments in Siegel's Stocks for the Long Term. Now, I don't know who was right.

Brendan

Brendan,

My point was rather more simple. The average guess of where the economy is headed is better than most individual guesses. It is better to use the market as a guide to the likely business conditions ahead than listening to various individual commentators, as the market has a better batting average than the vast majority of individuals, no matter how intelligent. Of course, the market is not always right....and how could it be as we cannot know the future for sure.

I don't read anything about values into this, and comments on feedback loops, efficient markets etc seem like over analysing what I thought was a relatively simple message.

Rory

 

[joe sod]

a great quote on investing
"in the short term the market is a voting machine, but in the long term it is a weighing machine"

therefore the future prospects of a stock are not properly valued by the market today. There are many stocks that all participants know will have a great future in 5-10 years time but the market will not pay for that today. The market only values the current and immediate prospects of a stock. This is because stocks are traded every day therefore the future stock can be bought in the future with this analysis. The problem is that no one can tell when the future for a particular stock has arrived. This is the story with emerging market stocks today. Everyone knows that emerging markets are the future yet emerging market stocks are depressed today. Yet a few years ago it was a bull market because the market perceived that the future had arrived for emerging markets