Is the Market Wise?

Someone upboard said that they believe ignoring stock prices could cause trouble: “It encourages people to ignore the wisdom of crowds. That could be a big mistake.”

And I think that begs the question: is the market wise?

I don’t want to argue about the notion of whether crowds themselves are wise. Certainly there are problem domains where crowds do better, and I’m sure there are ones where they do worse.

But we have data about markets, and we know that they are irrational. I mentioned before a study that found that market returns are far higher than they should be if markets were indeed rational and efficient. We know they’re not.

Beyond that, I think the wisdom of the crowds argument ignores something very fundamental: not everyone in the market is trying to optimize for maximum long-term returns. In fact, it wouldn’t surprise me if the majority are optimizing for other things. For example, many people on Wall St. are concerned primarily with minimizing their career risk and optimizing their own personal incentives. If you run with the herd and are wrong, well, everyone else was wrong too. But if you go your own way and are wrong, you get fired. The risk/reward tradeoff is very obvious, and a huge driver of behavior. Likewise, if your customers leave you if you have poor performance for a couple quarters in a row, then you’re obviously you’re going to sacrifice long-term returns in order to try to shore up the short-term – otherwise your hedge fund isn’t going to exist any longer. Then there’s incentives, both direct and indirect: if your compensation is based on trading activity, then it’s likely you’re going to churn your clients portfolios and justify that to yourself as “optimizing” them. If you’re paid for assets under management, you’re going to bring in as much money to manage as possible even if that means a high likelihood of lower overall returns. There’s nothing nefarious about any of that – it’s just how humans are.

Retail investors, on the other hand, I strongly suspect are mostly optimizing for capital preservation, not for long-term returns. Humans experience far more pain losing some amount of money than they experience pleasure making that exact same amount of money. That’s a powerful bias, and we see it everywhere. It’s easy to say we’re focused on a long-term horizon, but it can get be stressful when we see our performance suffering dramatically in the short term as part of that strategy.

So even if crowds would be wise if they truly dedicated themselves to the problem of long-term returns, I just don’t think that’s what most market participants are trying to do. And that, I believe, is possibly why we see the market generate far higher returns over the long run than it should given the actual risk.

freecapital posted a link to the latest Howard Marks memo from Oaktree Capital. There’s a lot of good stuff in there, but here’s one quote:

One of the most notable behavioral traits among investors is their tendency to overlook negatives or understate their significance for a while, and then eventually to capitulate and overreact to them on the downside.

I think that’s one of the things that makes predicting the short-term market so difficult. It’s not like huge shifts in sentiment are based on some brand new risk that suddenly appears: it’s often based on risks that have existed (and people have been aware of) for a long time: China, interest rates, slow economic growth, trouble in the middle east, etc. If you become suddenly cautious when these risks actually manifest, you’ll sit out most of the market and miss most of the gains. Marks said that Oaktree became cautious around the middle of 2011. I remember some people saying on various boards they were going to cash around that time. But the market is up over 45% since then, even taking into account this latest dip.

Then, suddenly, a tipping point is reached and investor sentiment turns very sour. And it’s easy to look back and say well duh, look at all those risks! I should have predicted that! Of course China is having problems. Of course interest rates are going up. Of course the U.S. was pumping out record amounts of oil. How did I not see this downturn from 100 miles away? And the answer is that you did see it – long ago, in fact – but the actual timing of when the market will finally react, when that last straw is finally reached, is impossible to predict with any kind of consistency. And you sit out that market at your peril: it’s not like it just goes up in a straight line until it doesn’t. There are corrections along the way, sudden dips on news regarding those very risks above that make you think “well maybe this is finally it!” and then the market turns back up just as suddenly as it dipped. And then maybe it dips hard again (or maybe it doesn’t), and then recovers fast again and goes on to generate outstanding returns. Nobody knows.

So are markets wise? Maybe, but perhaps a more pertinent question is whether they’re even trying to achieve the same things we are. Because if not, then I’m not sure if any wisdom they manifest is even relevant.



For example, many people on Wall St. are concerned primarily with minimizing their career risk and optimizing their own personal incentives.

What do you mean, “many”. How about “the vast majority”?
Anyone who sticks consistently with substantially different approach is very likely going to be fired (or lose his clients) sooner or later because eventually, there’ll be a period of multiple years where he’s wrong.
There’s a negative Darwinian selection process going on.


Sometimes markets have a different agenda than you do…

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The wisdom of the crowd? Isn’t that the same crowd that is noted for the madness of the crowd?

Crowd behavior is emergent from individual behaviors, but individuals behave differently when under the influence of a crowd. To assume that the emergent behavior is somehow wise is, well, madness.

Benjamin Graham dubbed the peculiar behavior of the crowd that invests in stocks “Mr. Market”; he noted that Mr. Market wasn’t necessarily wise, but rather often exhibited what can only be called bi-polar behavior. The very essence of successful investing is to catch Mr. Market in one of his “down” moods, when he is offering good businesses at cheap prices.

Sort of like now.

On the other hand, there are times when Mr. Market is in a particularly exuberant mood. Then he demands excessive prices for the very same company that he was offering at discounted prices just prior.

No, I don’t think that there is wisdom in crowds at all. There might be wisdom in seeking the advice of a number of intelligent people before making a big decision. But, just to avoid the group-think that defines a crowd, I would ask those smart people the same question individually, not at the same time.

Tiptree, Fool One guide, crowd-averse