The 2004 book, The Wisdom of Crowds, by James Surowiecki, starts with a vignette about the famous British scientist Francis Galton set in 1906.
In the story, Galton travels to the county fair and finds a weight judging competition, where the crowd could wager on how much a fat ox weighed. For a sixpence, people could write down their wager and the closest person one a prize (but not the slaughtered ox).
More than 775 people placed a wager, some were farmers and butchers who could make reasoned estimates and some were everyday people hoping to get lucky.
Galton wanted to know what the average guess was since his scientific contributions were statistical in nature. He is credited with creating the concept of correlation and was an early supporter of the mean-reversion concept. (He also came up with the phrase ‘nature versus nurture.’)
He reasoned that the collection of guesses would form a bell curve and that the average would end up being a reasonable estimate. It turns out that he was right: the average guess was 1,197 and the ox ended up weighing 1,198.
Galton expected that all of the guesses by the non-butchers and farmers (the uninformed) would ruin the results of those in the know. When he saw the results, he decided that there was wisdom in the crowd.
The application for markets is simple: no one knows exactly what company is worth.
Theoretically, we believe that it’s worth the present value of its future cash flows. The problem is that we don’t know what those cash flows will be and what discount rate we should apply to bring them into today’s dollars.
We know that a stock, and therefore the whole stock market, has an intrinsic value, but it’s unobservable, we don’t know what the intrinsic value is.
Efficient market advocates argue that the price is the best signal of the value based on the wisdom of the crowd. Investors all over the world look at a stock, evaluate their prospects, make some estimates and assumptions and come up with an intrinsic value.
The efficient market folks say that their intrinsic value estimates, on average, are probably a very close proxy for the actual value, just like the crowds guess of the ox’s weight was only one pound away from the actual weight.
For the most part, I tend to agree with the efficient market theorists and, therefore, the crowd.
The problem, however, is that the crowd is made up of human beings that can be rational at times and completely crazy at times.
It’s not hard to find examples of the madness of crowds, I can’t help think of the recent ‘victory’ riots on the UConn campus after their NCAA win.
I realize that these are drunken college kids, but there are plenty of other examples like the Tech Bubble, housing bubble, Tulip-mania and Bit Coin prices (okay, that last one is probably drunk college kids again).
The strict efficient market people are right that prices contain all available information, rational and otherwise. Fortunately, over time, markets end up getting it right even if the gyrations can get as wild as a UConn after party.