Knowledge Through Candy: Together, We Know More Than We Do Alone
How many times have you heard someone refer to “The Market” as if it was practically a sentient being, complete with its own goals, motivation and personality quirks?
Obviously, that’s not the case. We know that rather than being its own independent entity, at its core, “The Market” is simply a collection and reflection of the thoughts, opinions, hopes and fears of all market participants.
Every day, investors effectively meet at “The Market” to practice an exercise called price discovery: individuals work together – separately, yet collectively - to arrive at an agreed upon price for a stock, bond, or some other asset.
Some investors may think this agreed upon price is too high and will choose not to participate in buying. Others may think the price is too low and will refuse to sell. Ultimately, the group mentality of “The Market” finds a price where buyers and sellers will sufficiently agree for trades to go through. Even though “The Market” includes non-participants, the upshot is that together, we know more than we do alone.
We recently demonstrated this concept in a much tastier way than using charts and graphs of stock prices. At a recent client event, we put a jar of jelly beans on a table and asked attendees to guess how many jelly beans were inside. To make it interesting, we said that whoever got closest to the actual number got to take the jar home.
35 participants offered a guess, ranging from 427 on the low side to 25,000 on the high side. We had one attendee whose guess was only 49 away from the true count of 1,575 jelly beans, and the average guess was 2,047.
At first glance, it would seem like our participants didn’t demonstrate very good collective knowledge. But that’s distorted a little bit by the maximum guess, which was 20,000 more than the next highest guess. If we exclude that one outlier, the average comes down to 1,372 jelly beans, which would have been the fourth most accurate guess. That's pretty darn good.
We’re not the only advisory firm to try this experiment. In almost every case, the average of all guesses usually comes close to the actual amount of jelly beans, coins, gumballs, or whatever else advisors can think of stuffing into a jar. The combined intelligence of a group tends to be better than the knowledge of a single individual.
This simple concept illustrates why it’s so difficult to beat “The Market” on a regular basis. Consider for a moment that, in 2015, there were an average of 98.6 million equity trades placed each day, resulting in a daily average dollar amount of $447.3 billion. This is the staggering backdrop against which investors who try to beat “The Market” are facing. They are counting on their superior intellect (or illegal inside information) to identify assets or asset classes that the collective intelligence of “The Market” hasn’t properly priced. That’s a pretty daunting task.
And yet, this is the entire premise behind actively managed mutual funds, where a manager determines what to buy and when to buy it, with the goal of beating “The Market” as a benchmark.
The graveyard of individual stock pickers and market timers is littered with failed geniuses who couldn’t live up to this premise. The chart below (courtesy of Dimensional Fund Advisors) indicates the challenges faced by stock fund managers who tried: of the 3,711 equity funds that existed in 2010, only 29% outperformed their benchmark over the next 5 years. Going all the way back to 2000, only 17% outperformed over the following 15-year period.
“The Market” isn’t always going to get the price right. Sometimes, folks go a little crazy and drive prices way up or way down above where they should be. But it’s really hard to take advantage of those times over a lifetime of investing. Instead, investors are better off taking advantage of combined intelligence and simply capturing market returns.
That’s the sort of investing we do for clients of Woodward Financial Advisors. If you would like to talk about how we might be able to do that for you, please let us know.
 Source: The World Federation of Exchanges