In 1907, a man named Francis Galton discovered something fascinating at a fair. He noticed that when 787 people guessed the weight of a cow, the average guess was almost exactly right. This showed the power of the “wisdom of crowds” – the idea being that a group of people can produce a very accurate answer, often better than an expert could alone.
One would think that this concept would apply well to the stock market, where lots of well-informed, highly educated investors try an assess the fair value of the assets they are buying and selling daily…but it doesn’t. The stock market doesn’t always follow this wisdom. Why is that?
For the wisdom of crowds to work, we would need:
- Different Thinking: People need to think differently, even if they have the same information.
- Independent Thinking: Everyone must make up their own mind, not just follow what others are doing.
- Combined Thinking: There needs to be a method to combine all these thoughts.
Asset prices do gather individual opinions, but the problem is that not everyone is thinking independently or differently enough. This is especially true during market crashes or bubbles, where people tend to think and act the same.
In addition to this, it is at such times where investor decisions are most likely to be influenced by the behaviour of others. Extreme events in markets will be generated and sustained by the shared stress, fear, and excitement of the crowd.
This lack of diverse and independent thinking leads to market inefficiencies, meaning that sometimes, the price of a stock doesn’t truly reflect what the company is worth. One reason why is that not everyone in the market is trying to figure out the true value of the companies.
People invest for many reasons.
Investors might be passively following a market cap index, they might be chasing price momentum, they might be attempting to assess which company has the best earnings revisions prospects over the next 12 months or simply predicting how other investors will react to the latest news.
All are valid approaches, but none require the estimation of a security’s fair value. This is like if everyone at the fair was guessing the weight of different animals, not just the cow – their average guess wouldn’t be useful for finding the cow’s weight.
However, these inefficiencies in the market can create opportunities for investors who know how to use them. Here are some tips on how to do that:
- Learn As Much As You Can: The more you know about how markets work and why they sometimes don’t, the better you’ll be at spotting opportunities.
- Do Your Own Due Diligence: Don’t just follow the crowd. If you’ve done your homework, trust your own judgment.
- Manage Your Emotions: It’s easy to get caught up in the excitement or fear of the market. Try to stay calm and stick to your plan.
- Be Patient: Sometimes it takes a while for the true value of a stock to be recognised by the market. You might need to wait for your investments to pay off.
- Avoid Confirmation Bias: Listening to different viewpoints can help you see the full picture and make better decisions.
- Develop Your Analysis Skills: Learning how to read financial statements and understand market trends can help you find undervalued stocks.
By following these strategies, investors can take advantage of market inefficiencies for their gain. It’s about being smart, patient, and sometimes going against the mainstream. This way, the challenges of the market can actually become opportunities for those who know how to navigate them.
The idea of the wisdom of crowds tells us more about why markets are likely to be inefficient (at times extremely so) rather than efficient. It also provides insights as to why taking advantage of that inefficiency is quite so difficult.
Episodes of acute inefficiency create the greatest opportunities in terms of the level of divergence from fair value, which will often be extreme. Exploiting them is, however, no easy task.
It will be incredibly difficult for us to escape the pull of the crowd or the specific issue that is the focus of their attention. Even if we do manage to separate ourselves, we have no means of predicting when the behaviour will abate. Avoiding the madness of crowds can be painful and costly.
At Luthuli Capital, we’re here to help. Book a consultation now.