Author Jeffrey C. Hood contends that value investors might be aided in their pursuit of investment success by considering another view of the efficient market theory.
He began his book, “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” by raising two questions: First, do you believe the market is inefficient and that prices will eventually correct themselves? Second, do you believe a large and diverse crowd will probably make better decisions or be more accurate in its estimates than any individual, including experts?
In discussing the latter question, Hood introduced the 2005 book, “Wisdom of the Crowds: Why the Many are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations” by James Surowiecki. It set out four criteria, or characteristics, that are necessary for a crowd to arrive at the right answer:
- Diversity of opinion: Each individual has her or his own information.
- Independence: Individuals are not influenced by the opinions of others.
- Decentralization: These individuals can draw on local knowledge.
- Aggregation: A vehicle for converting private judgements into a collective decision.
Hood then asked whether the wisdom of crowds concept would work in the financial markets and concluded it would not—unless other criteria were added.
For example, the wisdom of the crowd might work when individuals in a crowd are asked to guess the number of jelly beans in a jar or the weight of an ox (both classic cases, first described by the scientist Frances Galton). But the crowd is unlikely to guess or estimate the value of a stock without “at least some information.”
Hood added, “As the difficulty of a question increases, an increasing number of the members of the crowd may not have the requisite information, or the proper analytical framework, to produce informed opinions. Thus it seems that we should explicitly add 'information' to our requirements for the applicability of crowd wisdom.”
This application of the wisdom of crowds to the financial markets prompted Hood to develop a list of six criteria; three of Surowiecki’s criteria (excluding aggregation) and three of his own:
- Incentives: Individuals have a good reason for providing what they think is the right answer.
- Independence: No person is aware of nor affected by the thoughts of others.
- Diversity of opinion: The crowd is comprised of individuals with different backgrounds, education, experience and so on.
- Decentralization: Individuals can make decisions without constraints imposed by bureaucratic or systemic environments.
- Knowledge: They have what Hood called “at least a modicum" of knowledge or experience—and use “an appropriate analytical framework”.
- Rationality: All individuals make their decisions in a rational way.
The author followed up with more detailed explanations for the inclusion of these criteria, and with his interpretation of the original criteria set out by Surowiecki. Here are some highlights from that section of chapter one.
- On the subject of incentives, Hood noted that the incentive is quite clear when members of a crowd try to guess the number of jelly beans in a jar. There is a prize, whether its all those candies or cash. When it comes to financial markets, the incentive becomes at least a bit muddied:
“In financial markets the primary incentive seemingly is to make money, which is not necessarily the same as correctly estimating stock prices. In particular, for professional money managers operating in a financial market the true incentives may be selfish ones, such as maximizing personal income, job security, career advancement, etc., which may not completely align with the goal of moving stock prices to their correct values. Incentives are an important consideration in virtually any human activity, and thus should be considered in any wisdom of the crowd scenario, especially one involving markets.”
- Discussing independence, he pointed to a couple of psychological considerations. One, “social influence” refers to the way in which individuals use the behavior or actions of others to determine how they themselves should think or act. Another, “anchoring” or “anchor points” refers to the fact that when people estimate numbers they tend to base them on irrelevant factors. For example, a share price recommended by someone in the media, or whatever an individual paid to purchase a stock.
- Diversity of opinion is linked to the distribution of returns in a statistical sense, such as the bell curve. Too many opinions on either tail would bias the sample. Hood wrote, “Without diversity of opinion, it is quite possible that people’s estimates would not be evenly distributed around the correct answer, but rather more estimates would be above the correct answer than below, or vice versa.”
- Free of bureaucratic or hierarchical management structure: While the stock markets appear to be free of such constraints, Hood did have one reservation. He wrote, “As one example, investment professionals tend to operate under a perverse incentive structure that incentivizes them to make decisions that detract from their long-term investment performance.”
- When he discussed knowledge, the author said just about everyone has enough knowledge to make an informed guess about the number of jelly beans in a jar, but in financial markets, “It may be that the decisions of those who lack the knowledge to provide an informed opinion may be equally scattered above and below (or equally scattered around) the correct answer, and thus may average out to virtual correctness. However, this cannot be relied on.”
- On rationality, Hood said decisions “should be made from an intellectually sound framework, without the corrupting influences of psychological influences, biases or emotion that would impair judgment.” He added, “In other words, lack of rationality is unlikely to produce answers that are evenly distributed above and below the correct answer, but instead is very likely to produce estimates that are either mostly above or mostly below the right answer. As we will see, lack of rationality has a huge effect on participants in financial markets.”
Conclusion
On the way to developing his inefficient market theory, Hood set a foundation based on the work of Surowiecki in “The Wisdom of Crowds.” He argued, however, that Surowiecki’s criteria for wise crowd decisions were not enough for accurate results in financial markets.
He created a list for financial markets made up of three criteria or characteristics from Surowiecki’s book and three of his own. The latter three were: proper incentives, some basic knowledge or intelligence and rationality.
In these criteria, there is also a hint of the efficient market theory, which will be addressed in the next chapter.
Read more here:
- Inefficient Market Theory: The Foolishness of the Crowd
- Ratio Analysis: The Payout Ratio
- Ratio Analysis: The Dividend Yield Ratio
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