By: Ryan Gavin, CFA™
Perhaps many remember the TV game show Who Wants to Be a Millionaire? Contestants would be asked a series of multiple-choice questions that grew progressively more difficult. Anyone who succeeded in answering all 15 questions stood to win $1 million. Whenever a contestant was stumped by a question, they could use one of three “lifelines.” One option was to remove two of the four answer choices, leaving the correct answer and an incorrect one. Another option was to phone a friend or a relative. Presumably, contestants chose someone before the show, selecting a person they considered very smart, and this approach worked quite well, being successful 65% of the time. The third option was having the audience vote on the answer they deemed correct, and this proved the most reliable lifeline of all, with a 91% success rate.
For any given question, it’s likely some audience members were sure what the correct answer was and others had no idea, but their collective wisdom would have been very difficult to beat. This concept is described by James Surowiecki in his book The Wisdom of Crowds, and it can be applied to financial markets as well.
Broadly speaking, markets are places where buyers and sellers transact at prices considered fair by both parties. Within that framework, a price can be viewed as an equilibrium point: If the price is too high, sellers will enter the market and push it down, and if it is too low, buyers will enter the market and push it up.
In markets where lots of smart people buy and sell, prices tend to adjust to a level that both sides regard as fair. Staying at The Ritz-Carlton costs far more than staying at the Holiday Inn, but both are successful businesses because their prices are considered fair by market participants.
What determines the prices (or equilibrium points) of financial assets such as stocks and bonds? Financial markets are giant information-processing machines, and asset prices represent their collective predictions about future performance. As expectations change, asset prices change accordingly.
This means investors making decisions based on predictions about things like gross domestic product (GDP) growth, changes in inflation, or the earnings growth of a particular company need to consider more than just the accuracy of their prediction(s). Instead, they should ask themselves the following question:
“What prediction is already reflected in the price, and is my prediction better or worse?”
This is essential for investors to understand. Accurate predictions about things fully reflected in prices shouldn’t be expected to produce excess returns.
In financial markets, extracting the predictions baked into prices is generally difficult to do, but there is evidence to suggest that markets do a pretty good job of incorporating information into prices.
For example, in 2016, Dimensional Fund Advisors published a study on the relationship between GDP growth and stock returns from 1975 to 2014 for developed markets and 1995 to 2014 for emerging markets. They found that even if investors had perfect foresight of the GDP growth of different countries over the following year, that information couldn’t be used to generate excess stock returns. In this case, future GDP growth was pretty accurately reflected in the stock prices.
This doesn’t mean financial markets are always right. If that were so, all financial assets would be risk-free. However, it does suggest that outwitting markets with lots of smart buyers and sellers is tough to pull off. The good news for investors is they can achieve solid outcomes without trying to outsmart markets. In fact, there is strong evidence suggesting that investors who don’t rely on market predictions achieve better outcomes than those who do.
Surowiecki, J. (2005). The Wisdom of Crowds. Anchor.
