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Stock Investing and the Wisdom of the Crowd

Value investor with a deep passion for understanding and a desire to improve results over time.

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Ox Estimates

Sir Francis Galton didn't know what to expect when he stumbled upon a state-fair-type event where locals were asked to guess the weight of an ox. This contest drew in some 800 participants, and Galton got ahold of the results. What he found was that the median weight was within one percent of the actual weight of the ox. How could it be possible that the crowd, collectively, was so much closer to the actual number than any individual guessing?

Fama and Academic Theory

Eugene Fama took this revelation a step further, formalizing the concept of the wisdom of the crowds into efficient market hypothesis. The central thesis was that markets (like the S&P 500) behave as though they reflect all available price information, and so the price could be considered "correct" on that basis at any given time.

EMH has been touted by the likes of Vanguard founder Jack Bogle, leading to the popularization of index fund investing, which nearly everyone uses today. Clearly, it is difficult for individual investors to beat the market, since nearly every individual retail investor underperforms the market, so Bogle prescribed buying the whole market, not just individual stocks, so you could simply rise alongside the inevitable (eventual) growth in prosperity.

Different Strokes

Clearly, there are folks who do consistently beat the market, though, and that seeming contradiction is worth zooming in, so we can get a closer look.

Efficient market hypothesis is real, and the wisdom of the crowds certainly exists. However, it's complicated. While, on the one hand, everyone in the world is looking at a particular stock, contemplating what the stock is worth right now, whether it's a buy or a sell, they're looking at the stock through their own particular lens.

Traders look at stocks along macroeconomic lines, with technical indicators in mind, or with fundamental valuation, including discounted cash flow or some other valuation method. But traders don't all have the same time horizon in mind, and that can change things a great deal. Let's unravel this thread a bit further.

Time Is on Someone's Side

So, why is the intrinsic valuation that the market assigns to a stock (its price) so different than what some investors think, and why are the individual investors sometimes "right" about that intrinsic value? Well, you really need to consider what inputs you use to calculate intrinsic value. No matter what method you use, time is always one of those inputs.

Time is the reason why a swing trader might think a stock is a good buy, given a one-month time horizon, but a buy-and-hold investor might think the same stock is a terrible value play for the long run. An investor with a ten-year investing time frame might consider fluctuations in a price that last for months at a time to be a feature, not a bug. But months of downward movement at a time simply won't work for a trader on a shorter time leash looking to make capital gains.

stock-investing-and-the-wisdom-of-the-crowd

All-Star Analysts

Since time horizon matters so much, and some investors care about volatility while others don't, and so on, then you can look at the price in the market as an average of all of these sorts of types of all-star analysts think. These analysts certainly know collectively what the price should be at a given moment, based on the median of all the gains or losses they expect from a stock.

It's incredibly important to understand that this hodgepodge of numbers is what makes the price what it is, and all of these different objectives are constantly battling one another. Ultimately, that's why there are so many great opportunities, even though the pricing is so efficient . . . it's just that the median comes from some people who think like you and have the same objectives, and a bunch of other people who don't.

Market Repricing and Opportunity

Market repricing is just these all-star analysts saying, oh, you didn't meet what we (who price the stock for a living) expected you to earn. If you're on a longer time horizon, perhaps there are too many short-term traders whose interests are disproportionately affecting a stock's price downward, and this is your buying opportunity. Or maybe longer term types are staying away from a stock with longer term headwinds, but you see that the next few months should look a whole lot better than they do right now.

But think for yourself: Is the company growing its earnings per share at a rate you think is reasonable, given today's stock price? If so, then the market agrees with you here, but it often overreacts, so you should always judge earnings by your own metrics.

Look for these opportunities, and remember that your goals and time horizon are your own. Keep in mind that the market takes everyone's time horizons into account, not just people who think like you and who share your objectives.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith