Jelly Beans and Investing Wisdom

It's every investor's dream: To outsmart the rest of the investing herd by consistently buying low and selling high. Unfortunately, many an investor has learned that this is easier said than done.

The truth is that the market—that collection of countless investors trading in stocks, bonds, commodities and more—is more skilled as a whole than are its individual participants. And that fact provides a key insight into how to invest successfully.

The collective market is a vast realm where opposing players compete against one another daily to buy low and sell high. In doing so, they help to set fair prices for everything from stocks to real estate.

Before the academic evidence showed us otherwise, it was commonly assumed that the best way to make money in what seemed like an ungoverned market was by outwitting others at forecasting future prices and trading accordingly. We know now that this approach is inherently flawed. One reason for that is that the market expresses a powerful group intelligence.

Research has shown that, at least on questions of fact, groups are better at consistently arriving at accurate answers than even the smartest individuals in that same group. There is one caveat: Each participant must be free to think independently. This, of course, is the case in our free markets.

And that's where the jellybeans come in. In his landmark book The Wisdom of Crowds, James Surowiecki presented and popularized the enormous body of academic insights on group intelligence.

In one experiment, 56 students guessed how many jellybeans were in a jar that held 850 beans. The group's guess—that is, the aggregated average of the students' individual guesses—came relatively close at 871. Only one student in the class guessed more accurately. Similarly structured experiments have been repeated under various conditions; time and again the group consensus has been among the most reliable counts.

Now consider how group wisdom translates to the market's multitude of daily trades. Each trade may be spot-on or wildly off from a "fair" price, but the aggregate average incorporates all known information about different investments, contributed by the intelligent, the ignorant, the lucky, and the luckless. This is why the current prices set by the market are presumed to be the best guide for one's next trades. The value estimates produced in this way are not perfect, mind you. But they are assumed to be the most reliable ones available in an imperfect world.

Why does this information matter to you as an investor? Because it serves to reinforce the futility of trying to outguess the market's collective wisdom. The market is the best forecaster of prices, period. So rather than trying to beat the market, smart investors focus on how to efficiently capture the returns that it delivers. We'll tackle that topic in a future blog. Meanwhile, please feel free to contact us if you'd like to discuss how we can help you make the most of your one financial life. It's who we are. It's what we do.