In chapter one of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd,” Jeffrey Hood argued that a crowd could only be wise in financial markets if it met six criteria.
Three of those criteria were taken from 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.”
But, according to the author, the Surowiecki criteria alone were not robust enough to judge whether crowds in the financial arena are wise. Thus, he added three of his own, for a total of six:
- Incentives.
- Independence.
- Diversity of opinion.
- Decentralization.
- Knowledge.
- Rationality.
In chapter three, he analyzed each of the six criteria in detail, to determine how well crowds in financial markets met them. He concluded:
“Therefore, of the six criteria (requirements) necessary for the wisdom of the crowd to apply in a financial marketplace, most of these are simply not met. The only requirement that clearly does seem to apply is knowledge. It appears that market participants have sufficient knowledge and/or experience that allows them to provide somewhat informed estimates or opinions. However, the key takeaway of the above analysis is that five of the six criteria required for crowd wisdom are either nonexistent, lacking to a considerable degree, or lacking at least during certain periods of time.”
Somewhat surprisingly, Hood concluded that of the six criteria for a wise crowd in the financial field, only one criterion has been met: knowledge or experience. That’s a subject I would like to focus on here (rationality is the subject of the next chapter, while the other four have been briefly discussed in chapter one and chapter two).
I was impressed by this distinction drawn by Hood: “In particular, this requirement [knowledge] can be viewed as having two components with respect to formulating votes on stock prices: 1) a sufficient amount of intelligence is being applied; and 2) the intelligence is being applied using a correct analytical or decision-making framework capable of producing a correct result.”
In his opinion, the second component is the real issue in determining if investors have enough knowledge to be a wise crowd. He went on to point out, for the purposes of his book, that the result of investors’ purchases in the stock market should be to drive current prices toward correct stock prices.
Next, he added, “In this author’s admittedly opinionated view, different investment approaches provide different levels or degrees of closure between the current stock price and the correct stock price. The most efficient is a bottom-up value-based approach which, when done correctly, does the best job of driving current stock market prices toward correct prices.”
In saying that a bottom-up, value-based approach is the most effective, Hood was stating it is more effective than the top-down and technical analysis approaches. As we know, a bottom-up, value approach requires extensive knowledge of a company’s fundamentals, and that takes time and effort.
But it is easier than the top-down approach, which demands knowledge of the global economy, the economic climate and choosing which sectors or industries to enter. All to try to figure out which area has the most potential so you can pick a stock in that industry or sector. A value-driven investor, on the other hand, works with past information and data that should help generate an intrinsic price which can be compared with the stock market price.
Obviously, when we work with past and current data, we work from a much more stable base than a top-down investor who has to correctly assess a whole list of issues before getting to a price for entry. Hood noted, “Thus the top-down approach may also do a fairly good job of driving stock market prices toward their correct prices, but not as efficiently as the bottom-up approach.”
In essence, it’s much easier to be a knowledgeable value investor than a knowledgeable top-down investor.
Turning to technical analysis, the author wrote, “Technical analysis does not involve assessing the intrinsic values of businesses and comparing these values to current stock prices. Instead, technical analysis attempts to predict movements in the market based on how people have behaved in the past.”
Hood added, “Given that the goal of technical analysis is NOT to close the gap between price and value, but rather to profit from predicted movements in stock prices based on previous price movements, it is difficult to see what role technical analysis plays in the 'wisdom of the crowd.'”
Some market participants prefer to use a form of modern portfolio theory, which the author called an “incorrect decision-making framework.” He rejects this as a basis for the wisdom of the crowd by noting it is based on assumptions that are incorrect, assumptions such as people are rational, markets are efficient and that risk can be quantified by measures of volatility.
And then there are some investors who buy stocks without much knowledge and without an analytical framework. They might buy good companies or companies in hot sectors, but if bought at the wrong prices, they are simply value traps.
Finally, he noted that the crowd in the market also includes computer-based trading algorithms, the ultimate in short-termism. He presumed these systems would most likely be neutral when it comes to converting current prices to correct prices because they would equally overestimate and underestimate correct values.
This all leads to the question: “Does a sufficient percentage of the 'crowd' of market participants utilize an appropriate analytical framework and hence provide informed estimates on stock prices?”
Hood’s answer: “Overall, it is probably best to conclude that this criterion is largely met, i.e., that market participants on the whole have sufficient knowledge and/or experience to provide judgments on stock prices that, in the aggregate, constitute a form of wisdom. However, the fact that so many participants in the market do not use a correct analytical framework in their stock investments is certainly troubling.”
Conclusion
In developing his theory of an inefficient market theory, Hood has explored how well the knowledge criterion works in financial markets.
He made an important distinction between knowledge, in the sense of the amount of intelligence being applied to pricing stocks, and the use of “a correct analytical or decision-making framework capable of producing a correct result.”
Evidence exists for both positive and negative assessments of the knowledge being used by crowds in the market, but on balance, he concluded there is enough knowledge to make the crowd wise. But, as we have noted, knowledge is the only one of six criteria that cleared the hurdle for a broader faith in the wisdom of crowds.
Read more here:
- Inefficient Market Theory: Challenging the Efficient Market Theory
- Inefficient Market Theory: The Wisdom of Crowds
- Inefficient Market Theory: The Foolishness of the Crowd
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