BUSINESS NEWS - Since the 1970s there has been a strong school of thought that markets are always efficient – that the current share price of any company is the most accurate reflection of its value.
This is why it is so hard for anybody to outperform the stock market over long periods of time: all of the information about any share is already in the price.
If this were completely true, however, markets would never go through the sort of bubble-and-bust cycle experienced in the dot-com era at the end of the 1990s. The prices being paid for shares in internet-related businesses at the time did not reflect their value, and when the bubble of irrational investor exuberance about these companies burst, a lot of money was lost.
This is a reflection of what behavioural scientists have known for decades – that humans do not always behave rationally, and that large groups of people can act in the same irrational way if they are presented with certain information in the same way.
It’s not so simple
To a large extent, markets are a reflection of these two competing forces:
“To be able to explain how prices work, you need to be able to be able to explain how on the one hand investors appear to be irrational, but on the other hand markets are very hard to beat over the long-term,” notes the president and chief investment officer at Morningstar Investment Management, Daniel Needham.
He argues that to understand this, investors should appreciate that share prices are not a reflection of a single cause and a single effect. Markets are ‘complex, adaptive, systems’, much like what one sees on a busy road.
As Needham explains: “If you are a driver, you make decisions, you influence the traffic. Then you respond to the traffic that you influenced, and then you respond again. These are called interactions. And as the number of drivers increases, and as time increases, the interactions increase exponentially to the point where they are computationally irreducible – you cannot predict the end point.”
How we get to a price
In markets, this does lead to efficiency most of the time due to the wisdom of crowds. This concept was illustrated by the famous jelly bean experiment conducted by Michael Mauboussin in 2007.
Mauboussin filled a jar with 1 116 jelly beans and asked his 73 students at Columbia Business School to guess the number. Their answers differed significantly, from a lowest guess of 250, to a highest of 4 100. The average individual error was 700, which is 60% off.
Yet, despite the inaccuracy of the individual guesses, their average (mean) was 1 151. This was just 3% away from the actual number, and only two students actually guessed closer.
What this shows is that even in situations where information is incomplete, a crowd predicts better than the individuals in it. A range of investors buying and selling a stock will therefore push that stock to an average – and therefore fairly accurate – price.
Yet this can break down …
However, for the wisdom of crowds to work, one very important factor has to be in place: diversity. In the stock market, this means investors operating independently and differently from each other.
Mostly, this is the case. Sometimes, however, it isn’t.
This is because, as humans, we are heavily influenced by the behaviour of others, particularly when we see that behaviour leading to some kind of benefit. This is, after all, how we learn language and appropriate social and cultural behaviour. It is in our nature to imitate what we see as successful.
“In certain environments, imitation is useful,” says Needham. “In others, it’s very dangerous. We think it’s particularly dangerous in markets.”
Where a large majority of investors starts behaving the same way, there is a breakdown in diversity and therefore the wisdom of crowds fails. That is what leads to mispricings, with major bubbles being the most extreme examples.
“Markets are inefficient when people are copying each other – when they are homogeneous, using the same decision rules,” Needham explains.
Where contrarians have an advantage
Markets are always at risk of this behaviour. On a large scale, it is what happened during the tech bubble of the late 1990s, but on a smaller scale it can constantly be seen in the prices of individual stocks or sectors that are either in or out of favour.
When prices are rising and investors are making money, other investors are attracted to that area of the market. When prices are falling, investors retreat.
There is a risk that this leads to investors selling low and buying high, but it also opens up opportunities for others who are willing to be contrarian.
Because if parts of the market are no longer operating efficiently, it means that share prices are not reflecting their true value.
These mispricings can be exploited by those investors who are willing to take the other side of the trade – to buy into falling markets and sell out of those that are overpriced. Theoretically, this might sound simple, but it takes discipline and courage to do it.
“Contrarians benefit from standing apart from the crowd, but there is no free lunch,” says Needham. “There’s a reason why these opportunities exist – because it’s hard to stand against the crowd. As humans we are susceptible to being heavily influenced by others.”