Key Investment Insights: Market Prices
July 31, 2014
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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.
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.
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.
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.