Are You Ahead of The Crowd?
Key Takeaways
3.5 billion trades on global exchanges on a monthly basis — the collection of these large numbers of trades helps in what academics call market efficiency.
Market efficiency posits that prices are fair to both buyer and seller which makes attempting to react to news or capitalising on ‘secret’ information extremely difficult.
Looking at a recent event and one 38 years ago shows that the wisdom of the crowds is hard to beat.
To have a successful investment experience; recognise that individually, we are unable to make accurate predictions; approach investing from a broad perspective.
The greatest enemy of a good plan is the dream of a perfect plan.
— John Bogle
Do you know how market prices are set every day, hour, or minute? It is through the collective buying and selling activities of millions of investors, not only from Singapore but from around the world. Some investors want to buy stocks, and others want to sell them. Some investors bid at very low prices, while others ask for very high prices. But whatever happens, the price of stocks eventually settles at a median price by a buyer and a seller who have agreed to transact at that value. That is how stock prices are set. And this process repeats itself day after day.
Source: World Federation of Exchanges. https://www.world-exchanges.org/
From the latest statistics published by the World Federation of Exchanges, there are on average around 3.5 billion trades on global exchanges on a monthly basis. That is a staggering number. The collection of these large numbers of trades helps in what academics call market efficiency. The Efficient Markets Hypothesis (EMH) simply states that it is quite hard to “beat the market” as prices tend to quickly reflect all available information about that asset.
But what does EMH have to do with anything?
It stems from a simple mistake that many investors tend to make when they try to make money by buying and selling their investments based on what they feel is “secret” or insider information. Essentially, they believe that this information should help them get ahead of the crowd, and enable them to make outsized profits. Before we assess the validity of such a belief, let’s first look at a recent incident.
19 Jul 2024: CrowdStrike (CRWD)
A cyber security firm called CrowdStrike pushed out an update for its anti-malware product and managed to create one of the largest IT outages in history. With millions of computers offline, there was general chaos in checking in people for their flights, buying coffee at Starbucks, disruption in rail travel, and even Amazon could not ship out packages on time amongst others.
It is likely that you, like many others only found out about this issue as more people started to get inconvenienced, and mainstream media picked it up and started reporting it widely. However, when this issue was still in its infancy, the stock market had already started to pay attention, as the timeline chart below shows.
According to the timeline of events pieced together from various technology websites, CRWD initially released the update to computers on the morning of 19 Jul (0409 UTC). Barely hours after the update started crashing Windows PCs around the world, the stock price of the company started tanking, ending up -14% on the first day itself. The corresponding two weeks since that incident has seen the share price collapse by nearly -40%.
The fact that CRWD’s share price started to reflect future revenue loss and the possibility of fines almost immediately — shows that somewhere, somehow, investors were already reacting to this event. Nobody could have predicted on 18 Jul that this US$3 billion revenue company would be upended by a programming error.
You may say that it was possible for news to be filtered through at lightning speed in this day and age of technological advancements. However, a lesson from another incident out of thousands of others also sheds light on market efficiency.
Back in the Day
On Jan 28 1986, the world tuned in to view the unfortunate tragedy when the space shuttle Challenger broke apart shortly after launch, killing all seven crew members aboard. In the initial aftermath of the incident, nobody knew what had happened and what was the cause. The only clues were from the video feeds that NASA had taken. As such, there were a host of theories about what had gone wrong — from issues with the fuel tank, a misfiring bolt, to problems with the booster rockets.
It was only after the conclusion of the Rogers Commission investigation, which took 5 months to complete, that the cause of the disaster was pinpointed as a faulty O-ring seal on the right booster rocket. Now, like modern-day aircraft, the space shuttle was not made by a single company but by a list of contractors. The companies involved in constructing Challenger were Lockheed, Martin Marietta, Morton Thiokol, and Rockwell International. However, only Morton Thiokol was involved in the construction and operation of the booster rockets of the space shuttle.
So in 1986, in an era without the internet, hard copy printed newspapers and few households owning the latest 386 computer (with 4KB of memory), how long did you think it took the stock market to price in what had happened? Spoiler alert: it did not take 5 months — which was when the report identified its culprit.
In their paper “The Complexity of Price Discovery in an Efficient Market: The Stock Market Reaction to the Challenger Crash” by economists Mulherin and Maloney, they dissected the stock price movements and found out that share prices reacted within minutes of the disaster (see chart below).
This data has far-reaching implications. What took a bunch of experts nearly 5 months to find out, took the stock market minutes to find out and in 1986 no less. Whilst all the other contractors involved in the project initially also had their share prices fall, only one company continued its downward path. You don’t need to be a believer in efficient markets to accept that the wisdom of the crowd is far superior to the individual.
What are the takeaways from this?
We have to trust that market prices are fair.
You may think stocks are very expensive, but the fact that there are people buying at the current price or bidding higher means that there are investors out there who feel it is still cheap. Who is right and who is wrong? No matter what analysts and market gurus say, there are enough people out there who hold an opposite view and who thus make sure the market price is always fair.
Individually, we are unable to make accurate predictions.
Trying to guess which stock or sector will do well, and which will not, will only increase your probability of a poor investment outcome.
Approach investing from a broad perspective.
The narrower your focus (single stocks or single countries like an overweight in Singapore companies) pushes you out of the crowd and into the individual space. This increases your chance for errors and could almost certainly guarantee a poor long term investment outcome.
As such, this is the reason why our core portfolios are built on this basis. For investments that we want to have high clarity on future risk and return outcomes, a broad reach and diversification are currently the most superior philosophy to adopt. You don’t need to go about trying to get the highest return by picking and timing investments. Like the quote by John Bogle (founder of Vanguard) at the beginning of the article, you don’t need a perfect investment plan. All you need is a good one.
For more information on how to build a good portfolio, contact us.
