Diversifying for a Smoother Ride

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Observation #1: A smoother ride builds confidence.

Observation #2: Confidence is important for the long-term investor.

 

In our last piece, “Managing the Market’s Risky Business,” we described how diversification plays a key role in minimizing unnecessary risks and helping you better manage those that remain. Today, we’ll cover an additional benefit to be gained from a well-diversified stable of investments: creating a smoother ride toward your goals.

 

Diversifying for a Smoother Ride

Like a bucking bronco, near-term market returns are characterized more by periods of wild volatility than by a steady-as-she-goes trot. Diversification helps you tame the beast, because, as any rider knows, it doesn’t matter how high you can jump. If you fall out of the saddle, you’re going to get left in the dust.

 

When you crunch the numbers, diversification is shown to help minimize the leaps and dives you must endure along the way to your expected returns. Imagine several rough-and-tumble, upwardly mobile lines that represent several kinds of holdings. Individually, each represents a bumpy ride. Bundled together, the upward mobility by and large remains, but the jaggedness along the way can be dampened (albeit never completely eliminated).

 

15 DFA Guesswork Investing

 

If you’d like to see a data-driven illustration of how this works, check out this post by CBS MoneyWatch columnist Larry Swedroe  “How to diversify your investments.”

 

Covering the Market

A key reason diversification works is related to how different market components respond to price-changing events. When one type of investment may zig due to particular news, another may zag. Instead of trying to move in and out of favored components, the goal is to remain diversified across a wide variety of them. This increases the odds that, when some of your holdings are underperforming, others will outperform or at least hold their own.

 

The results of diversification aren’t perfectly predictable. But positioning yourself with a blanket of coverage for capturing market returns where and when they occur goes a long way toward replacing guesswork with a coherent, cost-effective strategy for managing desired outcomes.

 

The Crazy Quilt Chart is a classic illustration of this concept. After viewing a color-coded layout of which market factors have been the winners and losers in past years, it’s clear that the only discernible pattern is that there is none. If you can predict how each column of best and worst performers will stack up in years to come, your psychic powers are greater than ours.

 


16 DFA Randomness of Returns

 

Your Take-Home

Diversification offers you wide, more manageable exposure to the market’s long-term expected returns as well as a smoother expected ride along the way. Perhaps most important, it eliminates the need to try to forecast future market movements, which helps to reduce those nagging self-doubts that throw so many investors off-course.

 

So far in our series of Evidence-Based Investment Insights, we’ve introduced some of the challenges investors face in efficient markets and how to overcome many of them with a structured, well-diversified portfolio. Next up, we’ll pop open the hood and begin to take a closer look at some of the mechanics of solid portfolio construction.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Moving On: The 401(k) Rollover Decision

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The Responsibility: Increasingly, Americans are responsible for their retirement savings.  For the most part, gone are the days of the 30 year employment tenure and the corresponding pension plan.   Individuals are on the hook for saving, investing, and managing their retirement savings during their working years, and into their retirement.  While  saving and investing in a workplace retirement plan, such as a 401(k), is an extremely important topic, let’s limit our focus here to what to do with your account during a transition-either into retirement or to another employer.  Specifically, should I rollover my 401(k) into an IRA (individual retirement account)?

The Options: Before you can answer this question, first review the options available to you, and the corresponding pros and cons.  Generally when you are ready to retire, the options for your 401(k) are as follows (your plan provider must give you the specific options for your plan):

– Roll the money into an IRA and hire a professional advisor or self-direct your investments

– Roll the money into a new employer’s plan (If you are changing jobs)

– Take a lump sum (Seldom recommended and generally you must pay 100% of the taxes due)

– Leave the money in the plan

Of these choices (if available), when retiring or changing jobs the decision often comes down to either rolling over to an IRA vs. leaving the money in the plan/ rolling to a new employer’s plan.  Because this is the most common decision individuals face, spelling out a few of the important pros and cons may help in the decision making process.

The Pros and Cons:

Pros: Do Rollover Because…

Cons: Don’t Rollover Because…

Investment Flexibility: The number of investment choices available to you through an IRA will most likely be greater than in your workplace retirement plan Creditor Protection: Retirement plans such as 401(k) plans offer tremendous creditor protection.  This protection is almost always greater than the $1 Million limit on protection in an IRA account.
Professional Management: If you work with a financial advisor, they can manage the IRA’s investments and coordinate your distributions.  An advisor also helps to review income tax implications of the account, and can make sure that your investments are in alignment with your financial goals. Costs: Depending on the arrangement, it may be more cost effective to leave your assets in a retirement plan.  Often there are low management fees, and often there are no transaction costs.  Carefully compare the total costs of your employer’s plan with the costs of professional management.
Costs: Costs to manage a retirement plan are often ‘trickled’ down to the plan participants.  These plan costs will not be passed to you in an IRA (although other costs may apply) Loans: Many 401(k) retirement plans offer the ability to take ‘loans’ from the balance of your account.  While there are pros and cons to this actual decision, the option to borrow from yourself is not available in an IRA
Roth Conversions: Once you have rolled your retirement plan into an IRA a Roth Conversion will be much easier to complete. Your Plan’s Distribution Rules: Some retirement plans may have specific rules related to rollover IRA distributions that may be restrictive and/or have additional costs
Inherited IRAs: IRAs and 401(k) retirement plans are passed on by beneficiary designations.  However, a beneficiary of an IRA can establish an inherited IRA easily, while a 401(k) beneficiary may be restricted by plan rules. Working past 70 ½: If you plan on working past age 70 ½ you may have the option to defer taking your Required Minimum Distributions (RMD)
Required Minimum Distributions: When you reach 70 ½ you must begin taking minimum distributions in either a 401(k) or an IRA.  Having a professionally managed IRA will allow you to carefully plan for and meet the RMD requirements each year. You Own Company stock in your 401(k):  If you own company stock in your 401(k) you will want to carefully consider the option to rollover as special tax considerations apply called Net Unrealized Appreciation.

 

One Final Note: Trustee to Trustee Transfer vs. Rollover Check.  If you do decide to rollover your workplace retirement plan into an IRA, a trustee to trustee rollover is often recommended because the assets simply move from one custodian to another.  If you personally receive a check for the rollover amount, your employer is usually required to withhold 20% of the total amount, and then you have only 60 days to deposit it into a new account + the 20% withheld, or it may be considered a distribution.  In addition you are only allowed to complete one such 60-day rollover per twelve month period.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Managing The Market’s Risky Business

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What is a simple, one word answer to the Question: How can we manage investment risks?

 

The Answer: Diversification

 

There’s Risk, and Then There’s Risk

Before we even have words to describe it, most of us learn about life’s general risks when we tumble into the coffee table or reach for that pretty cat’s tail. Investment risks aren’t as straightforward. Here, it’s important to know that there are two, broadly different kinds of risks: avoidable, concentrated risks and unavoidable market risks.

 

  • Avoidable Concentrated Risks

Concentrated risks are the ones that wreak targeted havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident, causing its stock to plummet. A municipality can default on a bond even when the wider economy is thriving. A natural disaster can strike an industry or region while the rest of the world thrives.

 

In the science of investing, concentrated risks are considered avoidable. Bad luck still happens, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally, as we described in our last post. When you are well diversified, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with plenty of other, unaffected holdings.

 

 

 

 

 

 

 

 

 

 

 

  •  Unavoidable Market Risks

If concentrated risks are like bolts of lightning, market risks are encompassing downpours in which everyone gets wet. They are the persistent risks that apply to large swaths of the market. At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (It may be worth less due to inflation, but that’s a different risk, for discussion on a different day.) Invest in the market and, presto, you’re exposed to market risk.

 

Risks and Expected Rewards

Hearkening back to our past conversations on group intelligence, the market as a whole knows the differences between avoidable and unavoidable investment risks. Heeding this wisdom guides us in how to manage our own investing with a sensible, evidence-based approach.

 

Managing concentrated risks – If you try to beat the market by chasing particular stocks or sectors, you are exposing yourself to higher concentrated risks that could have been avoided with diversification. As such, you cannot expect to be consistently rewarded with premium returns for taking on concentrated risks.

 

Managing market risks – Every investor faces market risks that cannot be “diversified away.” Those who stay invested when market risks are on the rise can expect to eventually be compensated for their steely resolve with higher returns. But they also face higher odds that results may deviate from expectations, especially in the near-term. That’s why you want to take on as much, but no more market risk than is personally necessary. Diversification becomes a “dial” for reflecting the right volume of market-risk exposure for your individual goals.

 

Your Take-Home

Whether we’re talking about concentrated or market risks, diversification plays a key role. Diversification is vital for avoiding concentrated risks. In managing market risks, it helps you adjust your desired risk exposure to reflect your own purposes. It also helps minimize the total risk you must accept as you seek to maximize expected returns.

 

This sets us up well for our next piece, in which we address another powerful benefit of diversification: smoothing out the ride along the way.

 

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

The Global Marketplace

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Map2

 

The World At Your Fingertips

As investors, we have the entire global marketplace available to us.  The image above shows the global capital market (the markets available for investment around the world). Like an atlas, the image is laid out loosely in the shape of the continents and countries.  Instead of national borders, however, each country’s outline is based on the size of its capital market relative to the entire global market.   The markets are then identified by their percentage size, and in color by the type of market, developed, emerging, and frontier.  Developed markets are in countries with stable political and economic atmospheres, and have transparent systems for accounting and regulation.  Emerging Markets are in countries that fall short in some way, whether it is the political regime or lack of market transparency.  Frontier Markets fall short in multiple ways, and are generally too risky for individual investment.

 

Capital Markets Vs. Economies

As you view the ‘map’ you will notice the relative size of the United States capital market, and in particular, the relative size of the Chinese market.  While China is the second largest economy (after the United States) by most measures, because of their political structure and their non-transparent systems for accounting and regulation, the actual size of their capital markets is relatively small and emerging.

 

How to Own the Global Market?

As investors, we want to participate in the growth of all of the meaningful global capital markets in approximate proportion to their overall composition (See: Diversification a Complete Meal).  By owning thousands and thousands of different types of companies around the globe through low-cost mutual fund investments, it is possible as an investor to take advantage of the constantly shifting flows of growth in a highly diversified and meaningful way.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Diversification: A Complete Meal

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What single action can you take to simultaneously dampen your exposure to a number of investment risks while potentially improving your overall expected returns? Diversification.

While it may seem almost magical, the benefits of diversification have been well-documented and widely explained by some 60 years of academic inquiry. Its powers are both evidence-based and robust.

 

Global Diversification: Quantity AND Quality

What is diversification? In a general sense, it’s about spreading your risks around. In investing, that means that it’s more than just ensuring you have many holdings, it’s also about having many different kinds of holdings. If we compare this to the adage about not putting all your eggs in one basket, an apt comparison would be to ensure that you’re multiple baskets contain not only eggs but also a bounty of fruits, vegetables, grains, meats and cheese.

 

While this may make intuitive sense, many investors come to us believing they are well-diversified when they are not. They may own a large number of stocks or stock funds across numerous accounts. But upon closer analysis, we find that the bulk of their holdings are concentrated in large-company U.S. stocks.

 

In future installments of our series, we’ll explore what we mean by different kinds of investments. But for now, think of a concentrated portfolio as the undiversified equivalent of baskets full of plain, white eggs. Over-exposure to what should be only one ingredient among many in your financial diet is not only unappetizing, it can be detrimental to your financial health. Lack of diversification can:

 

  1. Increase your vulnerability to specific, avoidable risks
  2. Create a bumpier, less reliable overall investment experience
  3. Make you more susceptible to second-guessing your investment decisions

 

Combined, these three strikes tend to generate unnecessary costs, lowered expected returns and, perhaps most important of all, increased anxiety. You’re back to trying to beat instead of play along with a powerful market.

 

A World of Opportunities

Instead, consider that there is a wide world of investment opportunities available these days from tightly managed mutual funds intentionally designed to facilitate meaningful diversification. They offer efficient, low-cost exposure to capital markets found all around the globe.

 

 

Your Take-Home

To best capture the full benefits that global diversification has to offer, we advise turning to the sorts of fund managers who focus their energies – and yours – on efficiently capturing diversified dimensions of global returns.

 

In our last piece, we described why brokers or fund managers who are instead fixated on trying to beat the market are likely wasting their time and your money on fruitless activities. You may still be able to achieve diversification, but your experience will be hampered by unnecessary efforts, extraneous costs and irritating distractions to your resolve as a long-term investor. Who needs that, when diversification alone can help you have your cake and eat it too?

 

In our next post, we’ll explore in more detail why diversification is sometimes referred to as one of the only “free lunches” in investing.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

 

Financial Gurus and Other Unicorns

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Do Financial Gurus exist? Yes.

Do Lottery Winners exist? Yes.

Do you want to invest your savings in lottery tickets? No.

 

While Financial Gurus (experts at identifying mispriced investments) do exist; the overwhelming evidence shows that these gurus are few and far between; or as Morningstar strategist Samuel Lee has described, managers who have persistently outperformed their benchmarks are “rarer than rare.”

As investors we are better served letting the market serve us, rather than attempting to outsmart the collective knowledge of all other investors.

 

Group Intelligence Wins Again

As we covered in “You, the Market and the Prices You Pay,” independently thinking groups (like capital markets) are better at arriving at accurate answers than even the smartest individuals in the group. That’s in part because their wisdom is already bundled into prices, which adjust with fierce speed and relative accuracy to any new, unanticipated news.

 

Thus, even experts who specialize in analyzing business, economic, geopolitical or any other market-related information face the same challenges you do if they try to beat the market by successfully predicting an uncertain reaction to unexpected news that is not yet known. For them too, particularly after costs, group intelligence remains a prohibitively tall hurdle to overcome.

 

The Proof Is in the Pudding

But maybe you know of an extraordinary stock broker or fund manager or TV personality who strikes you as being among the elite few who can make the leap. Maybe they have a stellar track record, impeccable credentials, a secret sauce or brand-name recognition. Should you turn to them for the latest market tips, instead of settling for “average” returns?

 

Let’s set aside market theory for a moment and consider what has actually been working. Bottom line, if investors who did their homework were able to depend on outperforming experts, we should expect to see credible evidence of it.

 

Not only is such data lacking, the body of evidence to the contrary is overwhelming. Star performers – “active managers” – often fail to survive, let alone persistently beat comparable market returns. A 2013 Vanguard Group analysis found that only about half of some 1,500 actively managed funds available in 1998 still existed by the end of 2012, and only 18% had outperformed their benchmarks.

 

Across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking.

  • Among the earliest such studies is Michael Jensen’s 1967 paper, “The Performance of Mutual Funds in the Period 1945–1964.” He concluded, there was “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”
  • A more recent landmark study is Eugene Fama’s and Kenneth French’s 2009, “Luck Versus Skill in the Cross Section of Mutual Fund Returns.” They demonstrated that “the high costs of active management show up intact as lower returns to investors.”
  • In the decades between, there have been as many as 100 similar studies published by a Who’s Who list of academic luminaries, echoing Jensen, Fama and French. In 2011, the Netherlands Authority for the Financial Markets (AFM) scrutinized this body of research and concluded: “Selecting active funds in advance that will achieve outperformance after deduction of costs is therefore exceptionally difficult.”

 

Lest you think hedge fund managers and similar experts can fare better in their more rarified environments, the evidence dispels that notion as well. For example, a March 2014 Barron’s column took a look at hedge fund survivorship. The author reported that nearly 10% of hedge funds existing at the beginning of 2013 had closed by year-end, and nearly half of the hedge funds available five years prior were no longer available (presumably due to poor performance).

 

Your Take-Home

So far, we’ve been assessing some of the investment foes you face. The good news is, there is a way to invest that enables you to nimbly sidestep rather than face such formidable foes, and simply let the market do what it does best on your behalf. In our next installment, we’ll begin to introduce you to the strategies involved, and your many financial friends. First up, an exploration of what some have called the closest you’ll find to an investment free lunch: Diversification.

 

Evidence-Based Investment Series #4: Diversification: A Complete Meal

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Fear and Greed: Repeat Until Broke

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Behavior Gap

 

 

Emotion + Investment = A Recipe For Disaster

The constant stream of information, daily stock prices, and the inevitable crises that inundate the news, all serve as a non-stop invitation for our emotional forces to enter into our financial and investment related decisions.  The result can be seen in the above illustration by Carl Richards.

When the universal human emotions of fear and greed (excitement is another word) influence our investment decision making, it becomes all too easy for us to ignore the evidence that tells us that markets are volatile, and that attempting to time the market or identify mis-priced investments will likely lead to poor long-term results.

Your Goals + Your Actions = A Recipe for a Plan

Instead of allowing our behavior to sabotage our long term goals, focus on the the things that you can control over time. Save, invest, re-balance, delegate responsibility, manage costs, set goals, and enjoy life!

 

Image Attribution: Carl Richards, (c) Behavior Gap 2013

Ignoring the Siren Song of Daily Market Prices

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Do you try to go to the gas station as soon as the price of oil futures change?  Probably not.

(And if you did, the price will probably have already changed by the time you get there.)

 

News, Inglorious News

What causes market prices to change? It begins with the never-ending stream of news informing us of the good, bad and ugly events that are forever taking place. For example, when there are reports that a fungicide is attacking Florida trees, orange juice futures may soar, as the market predicts that there’s going to be less supply than demand.

 

But what does this mean to you and your investment portfolio? Should you buy, sell or hold tight? Before the news tempts you to jump into or flee from breaking trends, it’s critical to be aware of the evidence that tells us the most important thing of all: You cannot expect to consistently improve your outcomes by reacting to breaking news.

 

Great Expectations

How the market adjusts its pricing is why there’s not much you can do in reaction to breaking news. There are two principles to bear in mind here.

 

First, it’s not the news itself; it’s whether we saw it coming. When a security’s price changes, it’s not whether something good or bad has happened. It’s whether the next piece of good or bad news is better or worse than expected. If it’s reported that the aforementioned orange tree disease is continuing to spread, pricing changes may be minimal; everyone was already expecting doom and gloom. On the other hand, if an ingenious new fungicidal treatment is released, prices may change dramatically in reaction to the unexpected resolution.

 

Thus, it’s not just news, but unexpected news that alters future pricing. By definition, the unexpected is impossible to predict, as is how dramatically (or not) the market will respond to it. Once again, group intelligence gets in the way of those who might still believe that they can outwit others by consistently forecasting future prices.

 

The Barn Door Principle

The second reason to consider breaking news irrelevant to your investing is what we’ll call “The Barn Door Principle.” By the time you hear the news, the market already has incorporated it into existing prices, well ahead of your ability to do anything about it. The proverbial horses have already galloped past your open trading door.

 

This is especially so in today’s micro-second electronic trading world. In his article, “The impact of news events on market prices,” CBS MoneyWatch columnist Larry Swedroe explored how fast global markets respond to breaking news. Pointing to evidence from a number of studies among several developed markets, the universal response was nearly instantaneous price-setting during the first handful of post-announcement trades. In the U.S. markets, it was even faster than that.

News travels quickly, and prices can adjust in an instant. For Example, in the image below, the change in Berkshire Hathaway’s shareprice can be seen immediately after the purchase of Heinz is announced.

 

 

 

In other words, unless you happen be among the very first to respond to breaking news (competing, mind you, against automated traders who often respond in fractions of milliseconds), you’re setting yourself up to buy higher or sell lower than those who already have set new prices based on the news – exactly the opposite of your goal.

 

Your Take-Home

Rather than try to play an expensive game based on ever-changing information and cut-throat competition over which you have no control, a preferred way to position your life savings is according to a number of market factors that you can better expect to manage in your favor. In future Evidence-Based Investment Insights, we’ll introduce these factors to you.

 

But first, you may be wondering: Even if you aren’t personally up to the challenge of competing against the market, you may think you can select a pinch-hitting expert to compete for you. Next up, we’ll explore the strikes against that tactic as well.

 

Evidence-Based Investment Series #3: Financial Gurus and Other Unicorns

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Stocks and Bonds: The Fundamentals

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Stocks and Bonds

 

As an investor, it is important to gain an understanding (no matter how generalized) of what you are investing in.  Let’s start with stocks and bonds (and cash).  What are they?

 

Stocks

Stocks are typically ownership shares in a company.  As an owner of a stock, you are technically an owner of the company.  Pause, and let that sink in.  Think about all the stocks you may own (individually or in a mutual fund) and then say to yourself, “I own that company”.

As an owner you accept the many risks that could result.  On the other hand, your expected return for the risk associated with ownership is greater; and you usually get to participate in the earnings of those companies in the meantime.

Stocks are the most effective tool for those seeking to accumulate new wealth over time. But along with higher expected returns, they also expose us to a much bumpier ride (volatility), and increased uncertainty that we may not ultimately achieve our goals (market risk).

 

Bonds

Bonds are a form of debt.  If a company or government needs to raise money, they’ll often ask to borrow it.  Now, pause and let that idea sink in.  If you own a U.S. Treasury bond, for example; you have loaned the government money.

In return for lending money, as an investor you are entitled to an interest rate to make it worth your while.  Because bonds are often secured by property and governed by a specific agreement, they typically are considered less of a risk, and as a result they usually return less over time than compared to stocks.

Bonds are a good tool for dampening that ‘bumpy’ ride and serving as a safety net for when market risks are realized. They can also contribute modestly to a portfolio’s overall expected returns, but we don’t consider this to be their primary role.

 

Cash – While we talk about stocks and bonds as the two primary forms of investment, what is your alternative.  Probably cash.  So what is the problem with cash?

Simple, as an investment, in the face of inflation, cash and cash equivalents are expected to actually lose buying power over time, but they’re great to have on hand for near-term spending needs.

 

Summary

A simple guide for stocks, bonds, and cash:

  Expected Long-Term Returns Highest Purpose
Stocks (Equity) Higher Building wealth
Bonds (Fixed Income) Lower Preserving wealth
Cash Negative (after inflation) Spending wealth

 

By keeping your attention focused on the larger principles guiding investment in stocks and bonds, it becomes easier to recognize that each type of investment in your overall portfolio serves a specific purpose in your total wealth management plan.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

You, The Market, and The Prices You Pay

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Have you ever heard the expression: Together, we know more than we do alone.

It is simple and powerful. It also describes the market, really well.

 

You, the Market and the Prices You Pay.

When it comes to investing (or anything in life worth doing well) it helps to know what you’re facing. In this case, that’s “the market.” How do you achieve every investor’s dream of buying low and selling high in a crowd of highly resourceful and competitive players? The answer is to play with rather than against the crowd, by understanding how market pricing occurs.

 

The Market: A Working Definition

Technically, “the market” is a plural, not a singular place. There are markets for trading stocks, bonds, sectors, commodities, real estate and more, in the U.S. and around the globe. For now, you can think of these markets as a single place, where opposing players are competing against one another to buy low and sell high.

 

Granted, this “single place” is huge, representing an enormous crowd of participants who are individually AND collectively helping to set fair prices every day. That’s where things get interesting.

 

 

Group Intelligence: We Know More Than You and I

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.

 

Unfortunately for those who are still trying to operate by this outdated strategy, a simple jar of jelly beans illustrates why it’s an inherently flawed approach. Academia has revealed that the market is not so ungoverned after all. Yes, it’s chaotic, messy and unpredictable when viewed up close. But it’s also subject to a number of important forces over the long run.

 

One of these forces is group intelligence. The term refers to the notion 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 … with a caveat: each participant must be free to think independently, as is the case in our free markets. (Otherwise peer pressure can taint the results.)

 

Writing the Book on Group Intelligence

In his landmark book “The Wisdom of Crowds,” James Surowiecki presented and popularized the enormous body of academic insights on group intelligence.

 

Take those jelly beans, for example. In one experiment, 56 students guessed how many jelly beans were in a jar that held 850 beans. The group’s guess – i.e., the aggregated average of the students’ individual guesses – came relatively close at 871. Only one student in the class did better than that. Similarly structured experiments have been repeated under various conditions; time and again the group consensus was among the most reliable counts.

 

 

Now apply group wisdom 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 contributed by the intelligent, the ignorant, the lucky and the lackluster. Thus the current prices set by the market are expected to yield the closest estimate for guiding one’s next trades. It’s not perfect mind you. But it’s assumed to represent the most reliable estimate in an imperfect world.

 

Your Take-Home

Understanding group intelligence and how it governs efficient market pricing is a first step in more consistently buying low and selling high in free capital markets. Instead of believing the discredited notion that you can regularly outguess the market’s collective wisdom, you are better off concluding that the market is doing a better job than you can at forecasting prices. Your job then becomes efficiently capturing the returns that are being delivered.

 

But that’s a subject for a future Evidence Based Investment Insights. Next up, we’ll explore what causes prices to change. Chances are, it’s not what you think.

 

Evidence-Based Investment Series #2: Ignoring The Siren Song Of Daily Market Prices

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.