Guessing the Weight of a Cow

I heard a radio broadcast recently about how successful a large group of people was at guessing the weight of a cow and how that shows the wisdom of the crowd.  That’s why it’s so hard to beat the market.

 Stories about the wisdom of crowds, the popularity of indexing, and celebrities picking stocks (in 2000 it was Barbra Streisand, in 2007 it was former baseball player Lenny Dykstra, and this year, it was a former Playmate of the Year) - all are signs of an aging bull market.  Teenagers also become investment gurus.  My all-time favorite was the teenage actress who was giving out day-trading advice.  And in a true sign of the times, New York Magazine wrote up a teenager who supposedly made $80 million trading after school - a story that turned out to be fake.

By contrast, at market bottoms you’re much more likely to hear stories about Chaos Theory and the Irrationality of Crowds - which amazingly appeared abruptly with the sudden crash in August.

The problem with relating the crowd wisdom phenomenon to investing is that there's more involved than just guessing a number when it comes to pricing a stock.  For example, stocks are bought and sold in a continuous auction market where investors are constantly reacting to stock prices.  Also, many investors follow strategies that have nothing to do with "guessing" the value of a stock (portfolio insurance and stock index arbitrage during the 1987 Crash are a good example).  And most importantly, money stirs up strong emotions - especially fear and greed - that affect the perception of value but that don't come into play in the cow scenario.

Brain scan studies have shown a much greater response in the brain to the size of a potential reward, like winning the lottery, than to either the probability of the reward or the probability times the reward (the expected value).  This bias can make it hard to plan for the future rationally and predisposes investors to risky behavior rather than rational valuation.

One good, but little-known, example of this irrationality and how it can have a dramatic effect on stock prices is the Panic of 1901.  Then, E.H. Harriman was trying to take over Northern Pacific Railroad by secretly accumulating stock, and as its price went up, speculators kept shorting the stock thinking it was overpriced. As Harriman continued buying, a short squeeze developed - especially after news came out about Harriman's purchases - and the price of Northern Pacific skyrocketed from $117 to over $1,000 as the shorts tried to buy the stock to cover their positions. In desperate need of cash to buy the now-soaring stock, the shorts had to sell their other stocks, which led to a full-blown stock market panic.

The result: the stock market went down sharply even though there was nothing wrong with the economy and no valuation (weighing a cow) reason for stocks to go down.  Bernard Baruch, a famous investor/speculator, understood that there was no fundamental reason for the decline - that it was just induced by a short squeeze which bled into a general panic - and he used it as an opportunity to buy up the shares of high quality companies at bargain prices. That's how he made his initial fortune.

The August 2015 mini-crash also occurred when there was nothing wrong with the economy, with a panic induced by some technical market factors like a lack of liquidity in the bond market and ETFs.  And an astute investor like Warren Buffett was able to take advantage of it, like Baruch, by buying $500 million of stock per week during the decline.