Standing out from the crowd

SERIOUS MONEY:MARKET EFFICIENCY, or the notion that stock prices are an unbiased reflection of value, underpins modern financial theory, yet few active investors place sufficient weight on its implications.

Active investors implicitly believe markets are inefficient, yet they routinely use financial models that were developed on the assumption that prices do reflect the wisdom of crowds.

Embarking on an investment strategy without a clear understanding of the rules of the game is hardly a recipe for success and calls into question the raison d'être of many active managers.

Investors need to be aware that stock markets satisfy the conditions that are likely to ensure prices reflect the best estimate of fair value. These conditions include: diversity, whereby individuals use different approaches and information to estimate prices; an aggregation mechanism, where individual guesses are converted into a collective estimate; and the existence of incentives that motivate individuals to be right.

Under such conditions the market price or the collective estimate will always outdo the prediction of the individual, and active investment management proves to be largely a function of luck or randomness.

For those who are sceptical, consider the work of Francis Galton. The father of eugenics, Galton was obsessed with measurement and, in a famous 1907 paper, Vox Populi, demonstrated convincingly the wisdom of crowds.

The paper detailed his observations at an ox-weighing contest, where almost 800 individuals paid a sixpenny fee to estimate the animal's weight.

The participants were motivated by the chance of winning a prize for the best guess. The average guess came to 1,197 pounds, versus an actual weight of 1,198 pounds. The surprising result has been repeated in several experiments over the years and only one sensible conclusion can be reached: collective wisdom is hard to beat.

The wisdom of crowds seems to suggest that active investment management is a waste of time and resources. However, all is not lost, as markets occasionally go awry. The existence of "black swans" or rare events, popularised by Nassim Taleb in his best-selling books, means that superior returns are possible.

Stock price movements do not conform to a normal distribution, as suggested by efficient market theory, due to the presence of outliers such as Black Monday in 1987 or the dotcom crash. Stock prices sometimes reach critical points, where a seemingly small change in fundamentals can produce an outsized effect.

Black swans are, by definition, virtually impossible to predict, but there are clues that help detect whether a rare event is a growing possibility.

The reason markets sometimes fail can usually be traced to a breakdown in diversity, when collective behaviour becomes remarkably similar.

Blake LeBaron has demonstrated how crashes happen. He writes that, "during the run-up to a crash, population diversity falls" as "agents begin to use very similar trading strategies as their common good performance begins to self-reinforce".

He notes that "this makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilising impact on the market". The mechanism is easy to understand in that "traders have a hard time finding anyone to sell to in a falling market since everyone else is following very similar strategies".

The existence of such a mechanism in the late-1990s is obvious given the widespread belief that no price was too high for high-flying, loss-making technology stocks. The number of mutual funds dedicated to "new economy" stocks soared as public enthusiasm grew, and even non-believers in the investment community were forced to participate due to short-term performance concerns.

However, those who left the party early were handsomely rewarded, as the record now shows that stocks have failed to keep pace with US Treasuries over the past decade.

The lesson for investors is clear. It is difficult to beat the collective wisdom of the market most of the time, but occasionally stock prices stray from their fundamentals and no longer reflect an unbiased assessment of value. Mispricing typically arises from a breakdown in diversity, which allows astute investors to benefit. Investors should assess the likelihood of a rare event and, in the presence of a diversity breakdown, panic early.

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