Conclusion: The ABCs of Behavioral Biases
We conclude our ABCs of Behavioral Biases series with a look at key lessons for recognizing biases and making more disciplined investment decisions.
Investment decisions can be influenced by everything from breaking news and market forecasts to our own emotions and instincts. In this series, we will explore some of the core principles behind evidence-based investing and how research can help investors make more informed, disciplined decisions. We begin with one of the most fundamental concepts: how markets determine the prices investors pay.
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.” How do you achieve every investor’s dream of buying low and selling high amidst a crowd of highly resourceful and competitive players? The answer is to play with rather than against market forces, 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 worldwide. For now, you can think of these markets in aggregate as a single place, where participants from all around the globe compete against one another to buy low and sell high.
Granted, this “single place” is enormous. Global financial markets process millions of trades worth hundreds of billions of dollars each day. It represents a huge number of participants who are individually AND collectively helping to set prices every day. That’s where things get interesting.
Before the academic evidence showed us otherwise, it was commonly assumed that the best way to make money in seemingly ungoverned markets was through a “lone wolf” approach known as traditional active investing.
To succeed, a traditional active investor seeks to become an expert at forecasting market pricing, so they can successfully pick stocks (pick/avoid future winning/losing stocks), and/or time the market (enter/exit ahead of rising/falling markets). In so doing, their goal is to earn higher returns than markets are expected to deliver “passively,” to anyone who is participating in them.
Unfortunately, consistently beating the market this way presents an enormous challenge. A simple jar of jelly beans shows us why. Academia has revealed that the market is not so ungoverned after all. Yes, it’s chaotic when viewed up close. But it’s also subject to a number of important larger forces.
One of these 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 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 college experiment, 56 students guessed how many jelly beans were in a jar that held 850 beans. The group’s aggregated average guess came relatively close at 871. Only one student in the class guessed closer 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 a “fair” price, but collectively, market prices incorporate vast amounts of available information and the expectations of the intelligent, the ignorant, the lucky, and the lackluster. Current prices therefore provide an important estimate of fair value based on the information available to market participants at that moment. It’s not perfect, mind you. But it’s a powerful information-processing mechanism in an imperfect world.
Understanding group intelligence and how it contributes to efficient market pricing is a first step in more consistently buying low and selling high in competitive markets. Instead of assuming you can consistently outguess the market’s collective wisdom, it can be more useful to recognize how efficiently markets generally incorporate available information into prices. Your job then becomes efficiently capturing the returns that are being delivered.
But that’s a subject for future Evidence-Based Investment Insights. Next up, we’ll explore what causes prices to change. Chances are, it’s not what you think.
This post was originally written and first distributed by The Writing Company.
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We conclude our ABCs of Behavioral Biases series with a look at key lessons for recognizing biases and making more disciplined investment decisions.
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