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Key Investment Insights: Market Prices

July 31, 2014

Is it possible to achieve every investor’s dream of buying low and selling high amid a large crowd of highly resourceful and competitive players? Though there is no clear-cut answer to this question, the way to achieve a positive response or outcome is to play with rather than against the crowd, and that is through an understanding of how market pricing occurs.

The Market(s)

There are markets for trading stocks, bonds, sectors, commodities, real estate and more, not just in the U.S. but around the globe. For now, consider these markets as a single place, where players compete, one against another, to buy low and sell high. Granted, this “single place” is huge but it represents an enormous crowd of participants who, individually AND collectively, help to set fair prices each and every day. And that’s where things get interesting.

Group Intelligence

Before academic evidence showed us otherwise, it was commonly assumed that the best way to make money in what was akin to an ungoverned market was by outwitting or out-thinking others at forecasting future prices and then trading accordingly.

Academia has revealed that the market is not so ungoverned after all. Yes, it is chaotic, messy and unpredictable, especially when viewed up close. But it’s also subject to a number of important forces over the long run.

One of these forces is group intelligence. The term refers to the notion that, at least on questions of fact, a group is better at consistently arriving at an accurate answer than even the smartest individual within that same group… with one caveat: Each participant must be free to think independently (as is the case in our free markets), otherwise peer pressure can taint the results.

Writing the Book on Group Intelligence

In his landmark book, “The Wisdom of Crowds,” James Surowiecki presented and popularized the enormous body of academic insights on group intelligence.

Let’s take jelly beans as an example. In one experiment, 56 students were asked to guess how many jelly beans were in a jar that held 850 beans. The group’s guess – i.e., the aggregated average of the students’ individual guesses – came relatively close at 871. Only one student in the class did better than that. Similarly structured experiments have been repeated under various conditions, and time and again the group consensus was among the most reliable counts.

Now, apply group wisdom to the market’s multitude of daily trades. Each trade may be spot on or wildly off from a “fair” price, but the aggregate average incorporates all known information, including that contributed by the intelligent, the ignorant, the lucky or the disinterested investor. Thus the current prices set by the market are expected to yield the closest estimate for guiding one’s next trade. Of course, using group wisdom is not perfect, but it’s believed to represent the most reliable estimate in an imperfect world.

Your Take-Home

Understanding group intelligence and how it governs efficient market pricing is the first step in establishing an effective strategy for investing in free capital markets. Instead of believing the now discredited notion that you can consistently outguess the market’s collective wisdom, you would be better off acknowledging that the market is doing a better job than you ever could at forecasting prices. Your job then becomes efficiently capturing the returns that are being delivered.

But that’s a subject for a future Key Investment Insights. Next up, we’ll explore what causes prices to change.



Eugene Fama Wins Nobel Prize in Economic Sciences

October 16, 2013

I am delighted that University of Chicago Professor Eugene F. Fama has been named a co-recipient of the 2013 Nobel Prize in Economic Sciences, in recognition for his contributions to the “empirical analysis of asset prices.”  I have actually waited for this recognition of Dr. Fama for some time, as he has been influential in my thinking and my career.  His groundbreaking empirical work inspired the founding of Dimensional Fund Advisors, a mutual fund company I use.  

Dr. Fama’s work in capital market theory has unquestionably enhanced my ability to help clients  have a successful investment experience and achieve their personal long-term investment goals.  Much of my understanding on how to identify and practically harness the relationships between market risks and expected returns is grounded in Dr. Fama’s work, which began in 1966, with the formation of the Efficient Market Hypothesis  In addition, Dr. Fama has made ongoing contributions to our understanding at Dimensional Fund Advisors’ public Fama/French Forum.

Nor has he worked in a vacuum. In his Nobel prize interview, Dr. Fama lauds his collaborators at the University of Chicago and elsewhere: “I couldn’t do what I did without the help of my professors at the time and colleagues since then and students since then.”  My finance professor at the University of Rochester was Michael Jensen,  one of Fama’s first graduate students.  Jensen, who carried out groundbreaking work on mutual fund performance, actually came up with the term “alpha”.  

Dr. Fama’s co-recipients are fellow University of Chicago Professor Lars Peter Hansen and Yale University Professor Robert J. Shiller.  For many on the inside of financial economic drama, the shared award comes with some bemusement, in that Dr. Shiller is often found at loggerheads with Dr. Fama regarding the role that market efficiency plays in investors’ decisions. In a Bloomberg column, 1987 Nobel laureate Robert Solow said that naming professors Fama and Shiller as co-recipients is “like giving a prize to the Yankees and the Red Sox.” 

As in any academic field, financial economists forever wrangle over points that may seem agonizingly granular to most of us, but that can still have significant impact on our daily lives – for good or for ill. In this case, the debate is approximately over whether overall market efficiency should lead us to patiently participate in the market throughout its volatile swings, or whether potentially predictable irrational investor behavior (bubbles) may justify trying to respond to shorter-term fluctuations. 

In light of the collective evidence available from professors Fama and others whose work I track, I remain convinced that your best financial interests are served – and your carefully planned goals most likely achieved – by avoiding the expenses involved in trying to profit from market irrationality. The practical hurdles continue to strike me as counterproductive in a long-term planning process. 

As we await the final denouement of seemingly endless shenanigans in Washington, let us celebrate thoughtful researchers who have helped us make sense of capital markets.  Their work has helped me sift through often-conflicting headlines related to financial economics and global news, by realizing that whatever information we are reading is very likely already reflected in current market prices.

The Right Investment Advice

March 14, 2013

While we only have a little more than two months under our proverbial belt, there’s no denying that it’s been a good run thus far in 2013.  Since January 2nd the S&P 500 Index has returned 9%.

In addition, all of the major indexes, the DJIA, the S&P 500 Index and the NASDAQ, have more than doubled since the low of March 9, 2009. This is a great reminder why you shouldn’t abandon your well-designed plan just because others are panicking.

On the flip side, any day now we can expect to see articles about why this is a good time to buy stocks.  Why few people were saying that in the depths of 2009 is a good question you might ask.

When the news was bad and markets were tanking, I advised staying the course and adhering to your investment plan.  Now I advise not getting too optimistic, thinking the “coast is clear.”

While we can all enjoy the recent successes, I certainly cannot take any credit for predicting the stock market rally.  The truth is that rallies come along quite randomly, as do stock market routs.  And as I’ve said on numerous occasions, no one can predict short-term stock market returns.  Just a reminder, stocks can go down as well as up.  Of course, you know that, but you also know that the long-term trend has been up.

So let’s bring up a subject I feel is critical to safeguarding your long-term investment experience: In good times and bad, there is an art to making quality decisions, and it may not be what you think.

Among the many roles of your financial advisor, one is to remind you (repeatedly) that the quality of your financial decisions contributes as much or more to your investment success as do the fleeting outcomes of hot or cold markets. In Carl Richards’ book, Behavior Gap, we are reminded of an important related insight: 

“The outcomes of our decisions may vary. In fact, you can make a good decision and have a bad outcome. But sensible, reality-based choices are our best shot at reaching our goals.”

To illustrate, you could take your life savings toLas Vegas, bet it all on a single very lucky spin and strike it outrageously rich. That would be a great, albeit improbable, outcome … to a very horrendous decision. In contrast, you can maintain a low-cost, globally diversified portfolio that reflects your personal goals as well as the latest academic evidence on capturing market returns. Fantastic decision, even when market conditions deliver disappointing results.

This is where your financial advisor comes in especially handy. Whenever you may be tempted off-course by undesirable outcomes — or, on the flip side, by random bursts of success — you need to objectively assess what, if any, adjustments might be warranted within your plans and your investments.

As Larry Swedroe points out:

“If you have done a good job developing your plan, and it has anticipated the risks you are likely to face, you should ignore the noise of the market, not getting caught up in either the hype or the fear that bull and bear markets can cause. Just stick to your plan.”

Making confident, quality decisions toward achieving your long-term goals regardless of past-tense outcomes — that is good advice any time of year.