In 1907 English polymath Francis Galton published an account of a forecasting competition that had taken place at a country exhibition in Plymouth the year before. He described how 787 participants had attempted to win prizes by correctly guessing the weight of a slaughtered ox. After reviewing the entries, Galton observed that the median guess was within 1% of the actual weight.[i] This remains one of the foremost examples of the idea of the wisdom of crowds, whereby combining a diverse array of independent opinions can lead to robust forecasts, often superior to those made by any individual.

The notion of the wisdom of the crowd is often applied to equity markets, particularly those arguing that they are (at least close to) efficiently priced. Unfortunately, the conditions for the wisdom of crowds to function do not hold for public equities. In fact, the behaviour of the crowd – in a variety of ways – creates inefficiencies rather than removes them. The inevitable presence of inefficiencies, however, does not make markets easy to beat or mean that we should even try.

For the purposes of this piece, we can assume that efficiently priced means to reflect the best collective estimate of an asset / markets’ value based on all available information. It is easy to see why the wisdom of crowds is a compelling description of how equity markets operate. We have a vast array of distinct investors making independent judgements. Doesn’t that get us to a similar situation to Galton and the Ox? Not quite.

As investors know only too well, crowds are not always wise. There are several characteristics required before we can begin to value their wisdom. [ii] The three most relevant are:

– Diversity of opinion: There does not necessarily need to be different information but, at least, the same information interpreted differently.

– Independent judgement: Views must be reached without the influence of others.

– There must be a means of collecting diverse opinions: There needs to be some means of aggregating group perspectives.

While equity prices are certainly an excellent way of collating the individual judgements of a participating group; applying the wisdom of crowds to equities breaks down when it comes to independence and diversity of opinion.

Although it may seem that the sheer number of participants in equity markets guarantees that prices reflect a varied range of perspectives, there will be times – particularly during market crashes or bubbles – where investor focus becomes trained on a very narrow set of ideas. In addition to this, it is at such times where investor decisions are most likely to be influenced by the behaviour of others. Extreme events in markets will be generated and sustained by the shared stress, fear and excitement of the crowd.

This destructive crowd behaviour leads to what we can think of as acute or episodic inefficiency. Where the price of an asset or security can diverge wildly from any reasonable assessment of fair value because the crowd / market has lost its independence and diversity of opinion.
 
It is not simply these bouts of dramatic crowd behaviour that prevent the market being efficiently priced. There is something else. Galton’s ox and other similar examples (such as judging the number of sweets in a jar) work because everyone involved is trying to guess the same thing. To believe that equity markets are efficiently priced because of crowd behaviour assumes that all or most of the crowd are attempting to make decisions based on their estimate of the fair value of the underlying securities. But they are not.

There are a huge range of motivations as to why investors make purchase and sell decisions, which have little relation to any assessment of long-run fair value. Investors might be passively following a market cap index, they might be chasing price momentum, they might be attempting to assess which company has the best earnings revisions prospects over the next 12 months or simply predicting how other investors will react to the latest news. All are valid approaches, but none require the estimation of a security’s fair value.

We can think of this situation as akin to Galton’s ox scenario, but where each participant is guessing the weight of a different animal – one a pig, one a sheep, another a goat. There is no reason to believe the average of such estimates will get us close to the weight of an ox.

Contrary to the aforementioned acute inefficiency, this is a chronic inefficiency. Where we should not expect the views of the crowd to equate to fair value (at any given point in time) because different people are forecasting different things.  

How might these two types of inefficiencies interact? Markets are typically in a state of chronic inefficiency where prices fluctuate based on the behaviour of investors with differing objectives, but with some slight gravitational pull from fair value. This will be punctuated with occasional bouts of acute inefficiency where investors (the crowd) move in concert and focus on a particular issue or story.  

If crowd behaviour means that there are both chronic and acute inefficiencies with markets unlikely to approximate fair value, does that mean everyone should be an active investor? No. Markets being inefficient does not mean they are easy to beat.

Episodes of acute inefficiency create the greatest opportunities in terms of the level of divergence from fair value, which will often be extreme. Exploiting them is, however, no easy task. It will be incredibly difficult for us to escape the pull of the crowd or the specific issue that is the focus of their attention. Even if we do manage to separate ourselves, we have no means of predicting when the behaviour will abate. Avoiding the madness of crowds can be painful and costly.

Although taking advantage of chronic inefficiencies may not be as emotionally exacting as escaping the fervour of a crowd, it remains a herculean challenge. Not only do we have to have a means of identifying some reasonable range of fair value for a security or an asset; we have to wait for it to be realised. If investors in aggregate are not attempting to find this fair value (because they are investing for other reasons) there is no reason for it to reach it anytime soon. So we need analytical prowess and (a lot of) patience.

The idea of the wisdom of crowds tells us more about why markets are likely to be inefficient (at times extremely so) rather than efficient. It also provides insights as to why taking advantage of that inefficiency is quite so difficult.

[i] A 2014 paper by Kenneth Wallis “Revisiting Francis Galton’s Forecasting Competition” found some discrepancies in the original work that actually served to strengthen Galton’s theory as the mean estimate of 1197lbs was found to have exactly matched the weight of the ox.

[ii] See James Surowiecki’s excellent  “The Wisdom of Crowds” for more detail on the conditions required for a ‘wise’ crowd.

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