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The Collective Knowledge of Markets

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 Peter Lazaroff By: Peter Lazaroff

Meet Penelope the cow. NPR’s Planet Money asked the internet how much Penelope weighed and got 17,205 responses.

The average of all the responses was 1,287 pounds and the actual weight was 1,355 pounds. The average was off by only five percent. This experiment, which was originally conducted in 1906 by Francis Galton, is a perfect example of the power of collective knowledge – together we know more than we do individually.

Every person’s guess reflects their unique knowledge and life experiences. Perhaps some participants knew the average weight of a cow is 1,500 pounds and considered that a female should weigh less. Other people may have looked at the man near the cow and determined that the cow was at least 10 times his weight. Every person’s estimate is a bit flawed, but also each person’s guess has a bit of information in it.

James Surowiecki explains this further in his book The Wisdom of Crowds:

 “If you ask a large enough group of diverse, independent people to make a prediction or estimate a probability, and then average those estimates, the errors each of them makes in coming up with an answer will cancel themselves out. Each person’s guess, you might say, has two components: information and error. Subtract the error, and you’re left with information.”

Another related experiment involves individuals guessing the number of jelly beans in a jar. In a September 2012 study, participants independently provided estimates that ranged from 498 to 9,999. The average guess was 2,716 and the actual amount was 2,650 – meaning the crowd was only a little more than 2% off the correct value.

This jelly bean experiment is frequently repeated with the crowd’s aggregate average usually being within 3-5% of the actual number. The larger the number of guesses, the more likely the average will be closer to the actual number.

The Collective Knowledge of Financial Markets

The collective knowledge of financial markets is one of the reasons we believe that market prices largely reflect all available information and expectations of the future. In more specific financial terms, we believe that the market is highly efficient.

Millions of market participants buy and sell securities around the world. The new information each buyer and seller brings to the markets help set prices. The errors in judgment from “dumb” money opinions offset each other as do the errors made by “smart” money. What you’re left with is information, and prices adjust according to each bit of new information.

Because the future is uncertain, we can’t know what the next bit of new information will be, but we believe it is reasonable to accept current prices as fair. If you believe the market is significantly mispriced – dramatically overvalued or undervalued – then you are pitting your knowledge or hunches against the combined knowledge of millions of other market participants.

What About Bubbles, Panics and Manias?

It is important to point out that in order for collective decision making to be useful, independence and diversity of opinions are crucial. Usually independence and diversity of opinion are missing from bubbles, panics, and manias – today’s market environment is a far cry from those conditions.

The Randomness of Beating the Market

The wisdom of crowds also supports the notion that most active managers won’t consistently outperform the crowd, and it is nearly impossible to predict who will be the winner in advance.

Let’s go back to the jelly bean experiment for a brief moment. When this experiment is run with the same group ten times, each time there are one or two people that have better guesses than the rest of the group. However, the one or two people with the best guesses are different each time and there is very little ability to predict which one or two people will have the best guess. There are a lot of implications to draw from this example, but the biggest is that outsmarting the group has a lot to do with luck, particularly when participants are highly skilled.

Rather than compete against the vast knowledge of the world’s market participants, a superior investment process involves harnessing the knowledge of markets and focusing on things that can be controlled such as risk exposure, costs, taxes, and investment behavior.

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Peter Lazaroff, Chief Investment Officer, first took an interest in investing when his grandmother gave him a single share of Nike stock for his 13th birthday. Today, nearly 20 years later, his investment insights are highly sought after by local and national media. More »

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