This post was originally made on May 15, 2006 on a former blog of mine.
As I mentioned in Efficient Market for What? I believe that financial markets are a great aggregator of information. My difference of opinion lies in what prices reflect. Efficient market theorists believe that the value of a company is always reflected in its price because all available information is almost instantaneously factored into that market price. I believe that a price in this type of market does not reflect the “real” underlying value of the company but rather it reflects the present whims of man and many other factors. There are far too many drastic swings both from a pure quantity perspective and from a magnitude perspective for it to be anything but.
I am revisiting this thought because it is a good starting point for today’s observations. There have been countless studies done that show that from a purely mathematical standpoint, predicting market direction and movement from past price trends is a random and artistic endeavor more so than a scientific one. In essence, there has yet to be a mathematical model built that can successfully build a crystal ball to see tomorrow’s prices for any extended period of time. To better understand the markets it is necessary to look at some of the less scientific aspects of them. The things I am about to discuss are more philosophical and less technical (and therefore probably refreshing to many people that have been reading this site for any length of time). These thoughts are observations about the interplay of crowd psychology, human emotion, collective intelligence, and chaos theory in relation to the working of capital markets.
In the book The Wisdom of Crowds, author James Surowiecki goes into great detail about how the collective intelligence of a crowd can be better than even the smartest individual at predicting certain things. He gives an example about placing something like 100,000 jelly beans in a giant container and having people guess at the total number of jelly beans inside. In many tests, the average guess of all of the people who guessed at the answer will ultimately be closer to the correct number of jelly beans than is the guess of any single individual. I liken this “aggregation of information” to the way the stock markets determine the price for a stock.
There are millions of people each with tiny bits of information and wisdom that they use to determine a price. The market price of a stock at any given time is a reflection of this information. The point that I want to make here, and one that is backed up by Surowiecki’s observations, is that a group of people thinking INDEPENDENTLY does much better at predicting things than do people operating with influence from the others in the group. In the example above, if you were to let each “guesser” hear the others guesses they might be swayed by those answers (whether they have cause or not) simply because they do not want to sound stupid or they really have no idea and need an anchoring point to start. In a situation like this the crowd’s collective answer is most often not as close to the correct answer as if they had all guessed independently. This idea of independent thought vs. interdependent thought meshes nicely with my next discussion about chaos theory in the markets.
At its most basic level, chaos theory basically describes systems whose reactions are very dependent upon the state of their initial conditions. One of the simplest model ideas to describe this is known as the sandpile game. The game is simply dropping grains of sand into say a one meter square area. After a period of time the pile is full of some areas that have rather steep slopes and some areas that are essentially flat with many other varying degrees of slope in between. At any point in time the addition of a single grain of sand can cause an avalanche if it hits an area with a steep slope. Scientists created this game to see if they could predict when and where the next great avalanche would occur within the game (this type of thinking has applications in many fields from earthquake prediction to forest fire prevention). What they’ve found is that these steep areas of instability organize themselves in a rather random and chaotic way and that they cannot predict what the addition of one more grain of sand ANYWHERE on the pile will do. In some cases it will be harmless and in others it will cause an avalanche of perhaps thousands of other grains of sand.
So what does this have to do with capital markets? Well, in an eloquently written chapter in Ubiquity: Why Catastrophes Happen
I am making this connection to illustrate a point which is once again echoed by Buchanan. Anytime there is a market collapse (like October 1987) we tend to look for answers as to WHY that happened and we will inevitably come up with many. Chaos theory tells us that the most minute of events could have indeed lead to that collapse and that trying to pinpoint the why is a futile game. One more grain of sand dropped on one very steep area of the market could have caused a ripple effect that bled out into the 20% loss of October 1987. There did not have to be a large “cause” behind it. It was simply a grain put in the wrong location.
This entire line of reasoning came from my desire to learn more about market psychology, bubbles, manias and the like. These are some very complicated topics and I urge you to read the above mentioned books for more thorough descriptions. I would like to leave you with one final thought.
Efficient market theorists believe that markets are now more efficient than ever because of the lightning fast speed at which information travels with all of our emerging technology. If interdependence, influence, and herd mentalities ultimately lead to market bubbles and collapses then I will go out on a limb and predict that these bubbles will come at more rapid intervals for precisely the same reasons the efficient market guys think markets are becoming more efficient. People now have access to social networks all over the world via the internet. We can now collect and process more information in a shorter amount of time. We have real-time news feeds, alerts to our cell phones, contacts in all parts of the world and certain things can influence us now more than ever. The fingers of instability are weaving their ways through the fabric of our markets and it will not take much more than a few grains here or there to influence massive amounts of people into running in/out of certain investments. We will eventually learn not to play this rapid game of musical chairs but until we have a few more periods of extreme unrest no one will be wise enough to step away from the game.
“The herd seek out the great, not for their sake but for their influence; and the great welcome them out of vanity or need.”-Napoleon Bonaparte
More on these topics (tags): bubbles, chaos theory, collective intelligence, crowd psychology, efficient markets, game theory, James Surowiecki, manias, Mark Buchanan, October 1987, ubiquity, wisdom of crowdsRelated Posts