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Robert Abbott
Robert Abbott
Articles (662)  | Author's Website |

Inefficient Market Theory: The Foolishness of the Crowd

A challenge to the idea of the efficient market theory may lead to a new approach for value investors

November 14, 2019

Few value investors subscribe wholeheartedly to the efficient market hypothesis (or theory) for the simple reason they know of so many exceptions. Warren Buffett (Trades, Portfolio) is the best-known example, but there are many others.

The theory proposes that stock market prices reflect all known information and, therefore, it is impossible to consistently outperform the markets. But, of course, many managers—and individual investors—do consistently beat the averages.

In his 2014 book, “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” Jeffrey C. Hood set out to explain why the theory does not work as described and goes on to lay out an investment approach based on what he calls inefficient market theory.

Hood is a lawyer, investor and co-founder of Austin Value Capital in Austin, Texas. On the firm’s website, he is described this way: “Mr. Hood's prior equity investment experience has involved considerable study and application of the value-based tenets of many of the great investors, including Benjamin Graham, Buffett, Charles T. Munger, Philip Fisher and Howard Marks (Trades, Portfolio), among others.”

He began by noting there are two main camps in the investment universe: active management and passive management. Behind active management is the assumption that the market is not completely efficient and, as a result, there are mispriced stocks. Further, there is a second assumption that with “the application of sufficient, knowledge, skill and expertise,” individuals can earn superior returns.

Passive management, on the other hand, assumes that “markets are efficient, or at least sufficiently efficient such that the marginal benefit of actively selecting stocks (the marginal profit made on an active strategy over a passive one) does not exceed the marginal costs of active management.” Essentially, passive investment is grounded in the efficient market theory. A corollary of this is that it is impossible for investors to “reliably and consistently” outperform the market using active stock picking.

With that, Hood argued investors should select an active or passive approach, based on two key questions:

  1. Do you think you can consistently and reliably generate returns using an active rather than passive strategy? He also adds two sub-questions: Do you believe the markets are inefficient, and can investors depend on these inefficiencies to correct themselves enough to produce a profit?
  2. If you believe the market is inefficient and that the inefficiencies will correct themselves, do you have the knowledge, skill, experience and temperament to find and act on them? Alternatively, do you think you can find a professional investment manager who can do this for you?

In response to the first question (which makes up the first part of the book), Hood cited Benjamin Graham, in an excerpt from “Security Analysis,” first published in 1934:

“This field of analytical work [discovery of undervalued and overvalued securities] may be said to rest upon a twofold assumption: first, that the market price is frequently out of line with the true value; and, second, that there is an inherent tendency for those disparities to correct themselves. As to the truth of the former statement, there can be very little doubt – even though Wall Street often speaks glibly of the ‘infallible judgment of the market’ and asserts that ‘a stock is worth what you can sell it for – neither more nor less.’”

Why did Graham think the market was inefficient? For the same reason investors think that way today: human nature.

Hood went on to address Graham’s second assumption, which is that stock prices will correct themselves over time. He observed that while Graham believed prices would correct themselves, undervaluation could “persist for an inconveniently long time.”

The author suggested investors today may have an advantage over their counterparts in the 1930s because there is much more information available, it is distributed more efficiently and there are “superior tools” (such as computers and spreadsheets) available.

The challenge to efficient market theory starts with the concept of the “wisdom of the crowd,” which states that decisions or opinions of a large number of diverse and rational individuals are likely to be better or more accurate than the decisions or opinions of any one individual—even if that individual is an expert.

While not a new idea, the wisdom of the crowd gained new attention and adherents with the publication of James Surowiecki’s book, “Wisdom of the Crowds: Why the Many are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations” in 2005.

Two of the examples used by Surowiecki came from the scientist Francis Galton. One was a case in which the median of 800 guesses by villagers about the weight of an ox was within 1% of the measured weight, and more accurate than the estimates of experts such as farmers and butchers. The second case involved guessing at the number of jelly beans in a jar; it was found that the average of thousands of guesses was more accurate than any one individual guess.

But Surowiecki also told his readers that not all crowds are equally good at making correct decisions, because not all crowds are created equal. Specifically, the accuracy of the crowd depends on its size, its make-up and its character. He laid out four essential characteristics for a “wise” crowd:

  1. Diversity of opinion, meaning that all members have their own ideas.
  2. Independence, that no one in the crowd is influenced by others in the crowd.
  3. Decentralization, which is the idea that people can specialize and work from local knowledge.
  4. Aggregation, which means there is a vehicle by which all these private opinions can be converted into a collective opinion or decision. For example, a contest involving the number of jelly beans in a jar.

Hood argued that Surowiecki also implicitly introduced a fifth characteristic, which was that members of the crowd had to have some minimal knowledge about what they were guessing at.

But are these criteria enough to make the wisdom of crowds effective in financial markets? That’s the crucial issue, one which will be taken up next in “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd.”

Conclusion

Many have written about the problems with the efficient market theory, but to my (admittedly limited) knowledge, no one has proposed inverting it into an inefficient market theory that will provide a pathway for better value investing.

Hood began his book about inefficient market theory with two core concepts. First, that active investing involves two challenges to effecient market theory. Specifically, that the market is inefficient and that prices will eventually correct themselves, allowing the investor to profit. Second, the concept of the wisdom of crowds, which argues that a large, diverse crowd is more likely to make the right decisions or guesses than any individual, even expert individuals.

For many value investors and market observers, the inefficient market theory may provide a new and unique understanding of crowds in markets.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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