Wisdom of crowds

Wisdom of crowds

Photo by davide ragusa on Unsplash

Given the current volatility in markets, it’s common to hear from investors, potential investors and the financial media expressing ideas for investing, or not, in certain companies, sectors or asset classes.  These views tend to be based on reasonable logic and seem like rational approaches to take.  However, it’s important to be reminded of how markets work and this is perfectly illustrated by events at a livestock fair in Plymouth in 1906.

In 1906 a Victorian gentleman named Sir Francis Galton attended a livestock fair aptly named The West of England Fat Stock and Poultry Exhibition in Plymouth.  One of the many attractions at the fair was a guess the weight of the ‘dressed’ ox on display (similar to the game of guessing how many cookies are in the glass jar).  The competition attracted 800 people all paying 6d (half a shilling) to write down their guess, name and address on the back of the ticket.  The nearest guess to the actual weight would win a prize.  The fair, as you can imagine, attracted many sorts, from the general public (old and young) to farmers and butchers.  Being a statistician, amongst many other things, Galton bought the used tickets off the stall holder.  Of the 800, 787 were usable.  Back home he analysed the guesses and published his finding in Nature, March 7, 1917 in an article titled ‘Vox Populi’ .  His remarkable finding is illustrated below.

Guessing the weight of the ox – the ‘crowd’ got it more-or-less spot on.

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The range of guesses was wide (-133 lbs. below the average to +86 lbs. above it), the participants were varied, and the numbers involved were quite large.  The ‘crowd’ in aggregate showed ‘wisdom’ compared to its individual participants.

This story provides a great insight into how modern financial markets work.  The markets are made up of many players, from individual DIY investors, day traders, stockbrokers, hedge funds, fund managers, sovereign wealth funds, endowments and other institutional investors.  Each investor holds their own view on the future prospects for a specific security, such as the price of BP or Apple shares.  Some will like a stock and others not – they can’t both be right.  The market – given all the information available to it – settles on an equilibrium price for every stock.  This price will move, sometimes dramatically, as we’ve seen recently as the ‘market’ reaches a new equilibrium price, given the new information that it has collectively processed.

At times like these, some investors are prone to running ‘what if’ scenarios in their heads such as: ‘if companies are in trouble because their revenues have been cut off, then they will renege on their property lease terms and the landlords will suffer.  It seems likely that things will get worse over the coming weeks.  If property landlords are in trouble that might lead to problems in the banking sector’.  It all sounds plausible.  They might then be tempted to sell out of property or banks or even equities altogether.  The crucial mistake is that they forget that they’re not the only person to have thought this through and these very sentiments and views are already reflected in the current price of listed commercial property companies, bank stocks and the markets in general.

Markets will move again – down or up – based on the release of new information, which in itself is random.  Second guessing random events is futile.  You might make a guess and be lucky but that is speculating not investing.  Accepting the ‘wisdom’ of the market helps us to challenge ourselves as to whether we really have superior insight relative to everyone else, which seems unlikely.

Making investment decisions and taking actions based on guessing – particularly when it relates to shorter-term issues that sit well within your true investment horizon – are best avoided.

Cheers

Charles

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results.