The wisdom of the crowds and market pricing

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

– Benjamin Graham

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Guess the number of jelly beans in a jar

In 2007, Michael Mauboussin, an adjunct professor of finance at Columbia Business School asked his 73 students to guess the market of jelly beans in a jar independently. 

He offered a reward of US$20 for the best guess and a US$5 penalty for a guess that is furthest from the correct answer.

Below is the result:

Range of answers: 250 to 4,100

Average: 1,151

Actual: 1,116

While individually, the class had individuals with widely incorrect guesses, the average of the guesses was just 3% off the actual correct number. Of the 73 estimates, only two were better than the average. 

Collectively, we are smarter than any individual.

You can see the wisdom of crowds in action. Most guesses are way off, but what is interesting is that when you have a large enough group, the average answer tends to be highly accurate - even more accurate than the best (or luckiest) guesser in the group.

This concept is not new — in 2005, New Yorker business columnist James Surowiecki wrote a book called The Wisdom of Crowds, exactly on this idea. And, this certainly can be applied to investing.

Wisdom of the crowd and the Efficient Market Theory

Markets are a crowd. Every time we buy or sell, we express our view on what a security is worth, and the collective decisions (whether right, wrong or just plain foolish) set the price. 

Individually, we may be way off in determining the 'right' price, but collectively, the markets weed out the outliers and aggregate the diverse choices of all participants into the market price.

Markets, though manmade, are a living and breathing organism. They efficiently absorb and process data, leading to continuous price discovery. In a fascinating manner, markets reflect a multitude of factors such as facts, opinions, weather, time, and even emotions, all down to the cent.

In the short term, we have seen periods of wild price swings in reaction to investor fear or greed, where fundamentals are thrown out of the window. However, over the long term, we believe that markets are efficient, and the crowds discover a price that is fair, with everyone's voice heard.

Read more: Can individual investors “beat the market”?

Even the “worst” investor can win

Investors tend to get rewarded in the long run, as markets collectively reset prices, despite short-run volatilities and price swings.

Meet Bob, our theoretical investor, who was “the worst market timer in the world” and only invests right before the market crashes by 20% or more.

• Bob invested $100,000 in March 1973, only to see it lose over 40% with the oil embargoes.
• After 15 years of saving and regaining his confidence, he invested $100,000 in August 1987, only to watch the markets dive 20% with Black Monday for no seemingly good reason.
• Sworn off investing, Bob sits out the next 13 years, witnessing one of the great bull runs of our time culminate in the rise of the dot-com era. He invested another $100,000 in December 1999 at the peak of the bubble, only to see the markets go down by 46% over the course of a few years of terrible events such as the terrorist attacks of 9-11 and the start of the war in Iraq.
• Bob is now near retirement. He gets a lifetime service award of $100,000 from his company, which he invested in the stock market in September 2007, just before the subprime mortgage crisis sent stock markets down over 50%.

Even with such bad market timing decisions, if Bob held onto his investment holdings until the end of May 2020, he would have $5,729,804, or a return of 1,332% on his $500,000 investment, an annualised internal rate of return of 7.93%. 

Bob wasn't a bad investor after all.

Harnessing the power of the markets — Stay disciplined, passively diversified, and rational

Market efficiency implies that it is very difficult to beat the market, and this has proven to be true.

Worrying about daily investment decisions and timing the market at the wrong time distracts you from what you should really be thinking about: positioning yourself in the markets for the long-term by buying and holding your investments to have the greatest chance of success in reaching your goals.

This means: 

• Staying passively diversified across sectors and geographies,
• Not trying to time the market,
• Making investment decisions at a risk level suitable for your goals and your behavioural inclinations, and
• Keeping your costs low and aligned.

On Endowus, we have curated evidence-based, low cost, systematic, globally diversified portfolios such as our Flagship Portfolios, learn more here.

We also provide CashUp and IncomeUp portfolios to meet your financial needs, whether you are looking to earn higher yields on idle cash or generate passive income.

Markets have historically rewarded long-term investors — harness the collective wisdom of the crowds and let the markets work for you.

Read more:

• Can individual investors “beat the market”?
• Rational investment strategies to win in a tumultuous market
• Introducing Endowus Flagship Portfolios: a core strategy for your financial goals

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