Each day, the world equity markets process billions of dollars in trades between buyers and sellers—and the real-time information they bring is what drives market pricing.
When it comes to investing (or anything in life worth doing well) it helps to know what you’re facing. In this case, that’s “the market.” Or, “Mr. Market,” as famed economist Benjamin Graham liked to say. How do you achieve every investor’s dream of buying low and selling high in a crowd of highly resourceful and competitive players? The answer is to play with rather than against the crowd, by understanding how market pricing occurs.
Technically, “the market” is a plural, not a singular place. There are markets for trading stocks, bonds, commodities, real estate and more, in the U.S. and around the globe. For now, you can think of these markets as a single place, where opposing players are competing against one another to buy low and sell high.
Granted, this “single place” is huge, representing an enormous crowd of participants who are individually AND collectively helping to set fair market pricing every day. That’s where things get interesting.
Photographer: You X Ventures | Source: Unsplash
Before the academic evidence showed us otherwise, most financial professionals assumed that the best way to make money in what seemed like an ungoverned market was by outwitting others at forecasting market pricing and trading accordingly.
Unfortunately for those who are still trying to operate by this outdated strategy, a simple jar of jelly beans illustrates why it’s an inherently flawed approach. Academia has revealed that the market is not so ungoverned after all. Yes, it’s chaotic, messy, and unpredictable 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, groups are better at consistently arriving at accurate answers than even the smartest individuals in that same group … with a caveat: each participant must be free to think independently, as is the case in our free markets. (Otherwise peer pressure can taint the results.)
In his landmark book “The Wisdom of Crowds,” James Surowiecki presented and popularized an enormous body of academic insights on group intelligence.
Take those jelly beans, for example. In one experiment, 56 students guessed 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; 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 “fair” marketing pricing. But the aggregate average incorporates all known information contributed by the intelligent, the ignorant, the lucky, and the lackluster. Thus, current market pricing is expected to yield the closest estimate for guiding one’s next trades. It’s not perfect mind you. But it’s assumed to represent the most reliable estimate in an imperfect world.
Understanding group intelligence and how it governs efficient market pricing is a first step in more consistently buying low and selling high in free capital markets. Instead of believing the discredited notion that you can regularly outguess the market’s collective wisdom, you are better off concluding that the market is doing a better job than you can at forecasting prices. Your job then becomes efficiently capturing the returns that are being delivered.
To see all 10 principles of Evidence-Based Investing at a glance, please visit our Evidence-Based Principles Guide. These principles inform our investing process.
Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.
10 Obstacles to Investing—and How to Overcome Them
Avoid These Investing Mistakes to Reach Your Retirement Goals (Part 1)
Why Stick with a Globally Diversified Portfolio? Principle 7 in Evidence-Based Investing
What Really Drives Higher Expected Returns? Principle 5 in Evidence-Based Investing
Understanding How Markets Work for You: Principle 4 in Evidence-Based Investing
Trying To Outguess the Market Has No Role: Principle 2 in Evidence-Based Investing
The Bumpy Road to the Market’s Long-Term Average
Don’t Let A Market Timer Gamble with Your Life Savings
Please log in again. The login page will open in a new tab. After logging in you can close it and return to this page.