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Are Markets Wise — or Probabilistic?

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Are Markets Wise — or Probabilistic?

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Are crowds collectively “smarter” than any one individual? Are markets all that efficient? How much does Mr. Market actually know about the future?

Investors have wrestled with those questions with limited success for a long time. The current sell off and recovery put these questions into even sharper focus.

In his book “The Wisdom of Crowds,” James Surowiecki described how large groups of people appear to be “smarter” than an elite few (no matter how brilliant) at challenges such as solving problems, reaching good decisions, or even predicting the future.

It makes for a fun narrative, but I suspect it overstates the case. Crowds often can and do make better decisions than individuals. However, to be superior requires a lot of factors to be working just right together. Lots of circumstances can occur where those factors are not present or in conflict, and market efficiency fails.

Perhaps the issue lay with the framing. Is it that crowds are wiser than individuals? It smacks somewhat of hindsight bias and narrative fallacy. Perhaps there are more nuanced to observations than what we tend to be implied by the standard “anthropomorphized” narratives. A more precise way to describe this:

Markets are probabilistic mechanisms, collectively allocating capital with imperfect information about an inherently unknowable future.

It Is not wisdom, but rather a statistical assessment of probable outcomes relative to asymmetrical payoffs. In other words, markets are risk-weighted betting machines.

Consider the complex system underlying stock markets: The “wisdom of crowds” is a colloquial way of describing market efficiency. When specific conditions exist – research shows this includes broad diversity of thought, widespread information dissemination / aggregation, and financial incentives – markets tend to be at their most efficient. When other conditions emerge – emotions, exogenous shocks, or randomness, markets become less efficient or can become derailed from underlying values. The betting goes haywire. (Note we also see this in prediction markets, which have had a rather mixed track record).

Hence, why I say markets are kinda-eventually-sorta-mostly-almost efficient.

This inherent tension between market efficiency and when humans derail that was perfectly recognized by the Nobel Prize committee in 2013. By awarding the Sveriges Riksbank Prize in Economic Sciences to both Eugene Fama and Robert Shiller, Stockholm recognized this schism. Fama’s thesis was pricing mechanism of markets were so efficient that they were difficult (if not impossible) to beat; Shiller’s data overwhelmingly showed that markets were often as irrational as the humans who traded them. Bubbles form, prices detach from reality, then crash back to Earth.

Which brings us back to the recent market action…

We need to be mindful of both hindsight bias and narrative fallacy as we describe what occurred after the fact in neat, easy to digest stories.

Instead, consider the external shock of the Coronavirus: It led to the fastest bear market in history and the recent strong snapback in a different framework: consider it in terms of a probabilistic mechanism allocating capital described above. It makes more sense to me than the wisdom of crowds narrative.

 

 

 

Previously:
The kinda-eventually-sorta-mostly-almost Efficient Market Theory (November 20, 2004)

How Shiller helped Fama win the Nobel (October 26, 2013)

MIB: Gene Fama & David Booth (November 9, 2019)

Prediction Markets

 

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