Have you ever entered a jelly bean contest, where you try to guess the number of jelly beans to win the jar? An interesting thing happens when you take the average of all the guesses.
Jack Traynor did exactly that. He brought a jar of beans (not the jelly kind) into two classes and asked the students to guess the number of beans inside. So the students attempted to count the beans, or estimate the beans per volume, or other such things to get their best estimate. Then they wrote down their guesses and turned it in.
Traynor found that in both classes the average of the guesses came very close to the actual number of beans. But what really stood out was that the average of the guesses beat all but one or two guesses. In other words, only one or two students actually did better than the average of the whole group.
This effect is known as the wisdom of crowds, but it requires a key ingredient:
These results suggest that, in situations where the subjects have not been schooled in a “correct” approach, the bulk of the individual errors will be independent, rather than shared. Apparently it doesn’t take knowledge of beans, jars or packing factors for a group of students to make an accurate estimate of the number of beans in a jar. All it takes is independence.
A crowd of bean guessers can be highly intelligent as a whole so long as their guesses remain independent.
Now replace beans with stocks and you get a sense of how the stock market works. As a collective, market participant’s guesses on asset prices come really close to the true value.
But it’s not perfectly accurate. Instead, the prices are close enough that little to no opportunity exists to earn a higher return (in most cases). Put simply, opportunity is priced out. So, in most cases, buying the market will get you returns similar to the growth of the underlying businesses (over time) and nothing more.
Of course, this is why the market is hard to beat. And some investors are okay with just owning the market. For others, like value investors, it’s not good enough.
Thankfully, it’s not perfect. Inefficiencies exist that create opportunities for value investors. Treynor calls it shared errors.
Independent errors (wrong guesses) happen in a large pool of bean guessers. So long as the pool is diverse and the guesses independent, the randomness of it all averages out to a collectively great guess.
But shared errors turn the wisdom of crowds into a hot mess. Traynor tested this with a second experiment — after recording the first guess — by “warning” the students with two bits of misinformation: there was air space at the top of the jar and the jar walls were thinner than normal.
It turns out, the new information skewed the average result enough to be worse than the original average guess by a factor of four. Traynor likened it to how published research might sway many guesses on a stock price.
Of course, research is just the tip of the iceberg for what might sway guesses.
Joel Greenblatt offered a simpler example of how shared error works using a tastier jelly bean test. Greenblatt twice asked a class of ninth-graders how many jelly beans were in a jar.
The first time, he asked the students to write down their guess on an index card. Once everyone turned in their card, he asked them again but to give their answer out loud. Only this time, they could keep their first guess or change it.
The results speak for themselves. The average of the first guess, written on the cards, was off by 5 jelly beans. But the average of the second guess, announced out loud, fell to roughly half the actual number of jelly beans. The kids, upon hearing their classmates guesses, collectively changed their answers for the worse. Greenblatt explained it like this:
I explained to them, the stock market is actually the second guess. Okay? Because everyone knows what they just read in the paper or what the guy next to them said or what’s on the news and are influenced by everything around them. And that was the second guess and that’s the stock market.
The cold calculating guess, when they were counting rows and trying to figure out what was going on, that actually was the better guess. That’s not the stock market, but that’s where I see our opportunity.
It’s a simple example of how easily shared error — biases — can be injected into market prices. Opportunities exist for this reason.
However, the difficulty is in recognizing the opportunities. Every ninth-grader who changed their answers for the worse thought it was for the better. Now how often do investors believe they made the wrong decision? And if decisions are easily swayed, it makes it hard to see real opportunities.
And it doesn’t take much to sway decisions. Something as simple as published stock prices are enough to influence an investor’s guess. This is why Buffett only looks at a stock’s price after he’s done a valuation.
So independent thinking is key.
But because the crowd is very often right, your guess — your analysis — has to be good too, more times than not. At least, good enough to suss out when the crowd is wrong by a wide enough margin to earn a solid return.
Then you have to act on it.
Because if you can’t act on it, none of it matters. And if you can’t guess better when the crowd is wrong…then you’re better off investing with the crowd.
Market Efficiency and the Bean Jar Experiment
**No posts for the next two weeks. I’ll be traveling and unplugged.**
- Humans are Hardwired to Dismiss Facts that Don’t Fit Their Worldview – Fast Company
- The Illusory Truth Effect: Why We Believe Fake News, Conspiracy Theories and Propaganda – Farnam Street
- News in the Age of Abundance – D. Perell
- Capital Camp 2019: Michael Mauboussin (video) – Capital Camp
- Useful Laws of the Land – M. Housel
- Is There a Green Bubble Forming?- Klement on Investing
- The Factor Archives: Value – OSAM
- 16 Leading Quants Imagine the Next Decade in Global Finance – Bloomberg
- Bruce Greenwald: Staying on the Right Side of the Trade – Value Investing with Legends