Last week I posted a theory as to why most investors or traders under-perform the market, and how the Wisdom of Crowds plays a role. I was full of shit. Here is my thinking now.
In the first place, I confused the total U.S. stock market with the S&P 500. Home bias is common, so it’s okay to exclude foreign stocks, but there’s no reason to exclude smaller-cap stocks.
Currently about 4,000 companies are publicly traded in the U.S. They are best represented by the CRSP U.S. Total Market Index. The S&P 500 contains just 13% of the total. According to Goldman Sachs data, the average return over the past 10 years for the U.S. Total Market has been 9.2%. That of the S&P 500 has been 13.6%.
The Total Market does worse because it includes lots of tiny companies on the verge of failing, whereas the S&P 500 has the advantage that laggards are continuously falling off and new leaders are being put on. To match the S&P 500 is actually to out-perform the total market by quite a bit.
What then about the Wisdom of Crowds? My analogy last week was faulty. The Wisdom of Crowds pertains to guesses by individuals who don’t know anybody else’s guess. The individual guesser is far less accurate than the average of all guesses. Crowds, when their individual thinking is averaged, are smart.
But in the stock market participants are constantly looking at “what other people have guessed” as reflected in prices. (The more people “guess” that a given stock should be bought, the higher that stock’s price.) Group think enters in. Crowds are smart but mobs are dumb.
I had grabbed at the Wisdom of Crowds as an explanation of an anomaly which I no longer think exists. I was thinking, how can the average person come in below average? There’s nothing to be explained.
In the first place, I confused the total U.S. stock market with the S&P 500. Home bias is common, so it’s okay to exclude foreign stocks, but there’s no reason to exclude smaller-cap stocks.
Currently about 4,000 companies are publicly traded in the U.S. They are best represented by the CRSP U.S. Total Market Index. The S&P 500 contains just 13% of the total. According to Goldman Sachs data, the average return over the past 10 years for the U.S. Total Market has been 9.2%. That of the S&P 500 has been 13.6%.
The Total Market does worse because it includes lots of tiny companies on the verge of failing, whereas the S&P 500 has the advantage that laggards are continuously falling off and new leaders are being put on. To match the S&P 500 is actually to out-perform the total market by quite a bit.
What then about the Wisdom of Crowds? My analogy last week was faulty. The Wisdom of Crowds pertains to guesses by individuals who don’t know anybody else’s guess. The individual guesser is far less accurate than the average of all guesses. Crowds, when their individual thinking is averaged, are smart.
But in the stock market participants are constantly looking at “what other people have guessed” as reflected in prices. (The more people “guess” that a given stock should be bought, the higher that stock’s price.) Group think enters in. Crowds are smart but mobs are dumb.
I had grabbed at the Wisdom of Crowds as an explanation of an anomaly which I no longer think exists. I was thinking, how can the average person come in below average? There’s nothing to be explained.
