Wisdom of the Market

Evidence-Based Insights: You, the Market and the Prices You Pay

Wisdom of the Market

When it comes to investing (or anything in life worth doing well) it helps to know what you’re facing. In this case, that’s “the market.” How do you achieve every investor’s dream of buying low and selling high in a crowd of highly resourceful and competitive players? The answer is to play with rather than against the crowd, by understanding how market pricing occurs.   

The Market: A Working Definition

Technically, “the market” is a plural, not a singular place. There are markets for trading stocks, bonds, sectors, commodities, real estate and more, in the U.S. and around the globe. For now, you can think of these markets as a single place, where opposing players are competing against one another to buy low and sell high.

Granted, this “single place” is huge, representing an enormous crowd of participants who are individually AND collectively helping to set fair prices every day. That’s where things get interesting.

Group Intelligence: We Know More Than You and I

Before the academic evidence showed us otherwise, it was commonly assumed that the best way to make money in what seemed like an ungoverned market was by outwitting others at forecasting future prices and trading accordingly.

Unfortunately for those who are still trying to operate by this outdated strategy, a simple jar of jelly beans illustrates why it’s an inherently flawed approach. Academia has revealed that the market is not so ungoverned after all. Yes, it’s chaotic, messy and unpredictable when viewed up close. But it’s also subject to a number of important forces over the long run.

One of these forces is group intelligence. The term refers to the notion that, at least on questions of fact, groups are better at consistently arriving at accurate answers than even the smartest individuals in that same group … with a caveat: each participant must be free to think independently, as is the case in our free markets. (Otherwise peer pressure can taint the results.)

Writing the Book on Group Intelligence

In his landmark book "The Wisdom of Crowds," James Surowiecki presented and popularized the enormous body of academic insights on group intelligence.

Take those jelly beans, for example. In one experiment Surowiecki mentions that 56 students guessed how many jelly beans were in a jar that held 850 beans1. The group’s guess – i.e., the aggregated average of the students’ individual guesses – came relatively close at 871. Only one student in the class did better than that. Similarly structured experiments have been repeated under various conditions; time and again the group consensus was among the most reliable counts.

Before Surowiecki, English scientist Francis Galton was a statistician who developed important concepts of correlation and regression toward the mean. He discovered in the early 1900s that the collective wisdom of many is more accurate than the wisdom of a few. Galton arrived at his discovery of "The Wisdom of the Crowds" at a livestock convention, where a crowd of almost 800 people were asked to guess the correct weight of a butchered ox. Surprisingly, the average guess of the entire crowd was very close to the ox's actual weight, only one pound off. No one individual came as close to the correct answer. In a 1906 Nature Magazine article titled, "Vox Populi" (Voice of the People), Galton concluded that a group of individuals making independent guesses would make a more accurate assessment than any individual would on their own2. The world's equity markets support Galton's discovery, as about ten million investors independently and collectively estimate the fair value of stocks every trading day.

Here is a current day version of Galton's experiment:

Now apply group wisdom to the market’s multitude of daily trades. Each trade may be spot on or wildly off from a “fair” price, but the aggregate average incorporates all known information contributed by the intelligent, the ignorant, the lucky and the lackluster. Thus the current prices set by the market are expected to yield the closest estimate for guiding one’s next trades. It’s not perfect mind you. But it’s assumed to represent the most reliable estimate in an imperfect world.

Your Take-Home

Understanding group intelligence and how it governs efficient market pricing is a first step in more consistently buying low and selling high in free capital markets. Instead of believing the discredited notion that you can regularly outguess the market’s collective wisdom, you are better off concluding that the market is doing a better job than you can at forecasting prices. Your job then becomes efficiently capturing the returns that are being delivered. 

At IFA, anyone who has visited our office in Irvine will likely have a fond memory of Francis, IFA’s probability machine. 

This elegant machine provides a useful model of how to think about fair prices and the resulting market returns. From these critical lessons, investors can develop better investing strategies and simulations of future returns. If you are interested in learning more about IFA, call us to speak to one of our experienced Wealth Advisors at 888-643-3133.


1 James Surowiecki, “The Wisdom of Crowds, copyright © 2004, 2005, Anchor Books. Jelly bean illustration is described in Chapter 1, page 5

2 Francis Galton, "Vox Populi," Nature, vol. 75, March 28, 1907