How many gumballs are in this gumball machine?
It turns out that if I took your guess, and every other guess from the people that read these notes, and averaged them all together, we’re going to get a number extremely close (if not spot on) to the correct answer. Writer and researcher James Surowiecki first documented this “gumball effect” in his 2004 book The Wisdom of Crowds.
Surowiecki’s findings have much broader implications than just winning a lot of gum. For one, financial markets represent billions of estimates and guesses from investors around the globe. If we’re all looking at the same market, how confident are we that it’s priced correctly? That is, does the market reflect all known information about itself?
While that question lives beyond the realm of scientific proof, it certainly fits the gumball theory. With all these billions of people estimating and trading based on what they think companies are worth, it’s likely that their individual estimates are adding up to the market’s true value. So if the market does reflect all known views, and those view averaged together are correct, it’s very tough to reconcile the idea of the market being either over- or under-valued. How can an entire market be over- or under-valued if it reflects all known information about itself, and all anticipated outcomes? This doesn’t mean that investors can’t change their minds about price, just that our collective view outweighs our individual views.
Keep in mind, though, that getting a good average means we need lots of observations. The gumball theory shows that the greater the number of observations, the more reliable the answer (and conversely, the smaller the number of observations, the less reliable the answer). This means widely-held companies are more likely to be correctly priced than closely-held companies. We actually do have some evidence of this, because we know that the price swings of widely-held companies tend to be smaller than those of closely-held companies. Smaller swings equals less surprises.
In all, this means the broad market is very likely to be priced spot on, large companies are very close to correctly priced, and smaller companies should be less correctly priced. If your game plan is investing in large well-known companies, sticking to good steady performance and positive fundamentals should reflect better opportunity than taking chances on struggling companies, turnaround situations, or games of chance. Successful companies will always be more expensive than failing companies, and for good reason.
I know this contradicts a lot of so called market wisdom about “following the herd” and such. But consider that the opposite of being a contrarian is not following the herd, its being a contrarian to the contrarian.
That’s something to chew on.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.