If the “foolishness of the crowd” in financial markets is predictable, could investors use that foolishness to make better investing decisions?
That’s the question raised by Jeffrey C. Hood in chapter five of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd.”
In previous chapters, he has argued that while crowds may good at things like guessing the number of jelly beans in a jar, that wisdom doesn’t extend to the investment world. That’s because of human irrationality and other factors.
Hood wrote, “Because of this, the following question presents itself: Is the Foolishness of the Crowd that manifests itself in the stock market sufficiently predictable and reliable to serve as a basis for investment decisions?”
The author answered that question in the affirmative as “a primary thesis of this book is that the Foolishness of the Crowd will also reliably and predictably manifest itself, to varying degrees, when certain conditions are present.”
The efficient market theory would have us believe that the crowd in the financial arena is almost always correct, but, of course, we know that is not true in practice. At all times, some portion of the market behaves irrationally, driven by everything from the desire to get rich quickly to what Charlie Munger (Trades, Portfolio) called the Lollapalooza effect.
What’s more, Hood argued that irrationality will generally affect people in the same way, in the same direction. This is most visible during booms and busts, when most investors in the market rush to a positive or negative extreme.
That portion of the market that is behaving irrationally is what Hood called the “Foolish Offset”. He noted:
“It seems clear that this 'Foolish Offset' will reliably be present to varying degrees under at least some circumstances. If the direction and amount of this offset can be estimated based on current market circumstances, or at the very least be anticipated to be present to a large degree under some circumstances, then intelligent investors can use their knowledge of the presence of this Foolish Offset, and their estimation of the amount of this offset, to help make informed investing decisions in the stock market.”
Put another way, there may be a “wisdom of the crowd” effect in financial markets, but it is not entirely wise. A portion of the crowd will also be foolish and drag stock prices away from correct (intrinsic value) pricing.
“Our contention is that, under at least some circumstances, this 'Foolishness of the Crowd' result, this Foolish Offset from a normally wise result, is as certain and predictable as many other attributes in a financial marketplace,” Hood wrote.
From that, he extrapolated investors who understand foolishness and can shield themselves from its pull are more likely to keep their heads at critical times in the market. They will be able to understand the foolish offset and perhaps even anticipate that mispricings will occur—and take advantage of them.
That sets the stage for Hood’s discussion of contrarian investing. He cited Howard Marks (Trades, Portfolio), who wrote in “The Most Important Thing” that “What’s clear to the broad consensus of investors is almost always wrong . . . . The very coalescing of popular opinion behind an investment tends to eliminate its profit potential.”
For Hood, the profit potential of a contrarian stance is based on three basic notions about the market: First, that the crowd’s views and opinions about stock prices do affect prices themselves. Second, there will be market efficiencies in the short term. And third, that market inefficiencies will correct themselves eventually or that the foolish offset will disappear over time.
Value investing is a familiar form of contrarianism, as investors bet against the crowd by buying discounted stocks that they expect will be corrected eventually. The second approach to contrarianism is to develop ways of taking advantage of the foolishness of the crowd, without fundamental analysis and working from intrinsic values. Hood wrote:
“While in this author’s opinion either of these two approaches can be practiced in isolation and lead to good overall results, by far the best investment results come from combining them. Thus, in addition to the classical value investing mantra of intrinsic value and margin of safety, a fundamental premise of this book is that the intelligent investor who is also acutely aware of the psychological and systemic forces at work in the stock market, and actively tries to identify and take advantage of these phenomena, is in a much better position to both detect and take advantage of these market inefficiencies.”
Conclusion
Hood began his book with the efficient market theory and the basic wisdom of the crowd phenomenon as described by James Surowiecki. He then went on to observe that the wisdom of the crowd fails in financial markets because of irrationalities and other factors (collectively, the foolishness of the crowd).
In chapter five, he became more specific by developing the concept of the foolish offset; it refers to that portion of the crowd in financial markets that is behaving irrationally, and the effect it is having on stock prices. Further, that foolishness is sufficiently predictable and reliable enough to help investors make better decisions.
Finally, Hood put forward the idea that combining the foolish offset with conventional value investing has the potential to make value investing even more effective.
Read more here:
- Inefficient Market Theory: Drivers of Irrationality
- Inefficient Market Theory: Knowledge and the Wisdom of Crowds in Financial Markets
- Inefficient Market Theory: Challenging the Efficient Market Theory
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