Beyond Reason: From Jelly Beans to 'Group Think'

Every once in a while the Economist publishes a great article that one can use to teach undergraduate economics students. In the February 23rd edition (page 90), the Economist turned a jar of jelly beans into a look behind stock market anomalies.

"Perhaps the most compelling reason why market prices are tough to beat is the 'wisdom of crowds' phenomenon.

If people are asked to estimate the number of jellybeans in a jar, their average estimate is usually quite close to the truth; indeed, the average guess is far better than the vast majority of individual guesses. In other words, , as Michael Mauboussin of the fund-management group Legg Mason remarks, the collective is smarter than the average person within the collective."

Wait for it ... the twist:

"But this wisdom depends on the diversity of the people making the guesses", without a high degree of diversity, "group-think" takes over and investors "no longer guess how many jelly beans are in the jar, but what other people's guesses might turn out to be".

A little clearer: "There is an old test that neatly makes this point. Participants have to choose a number between zero and 100 that will be two-thirds of the average choice of the others taking part. So if you thought the average would be 50, you would go for 33. However, if everyone makes this logical leap, the best guess should be 22 (two-thirds 33). Extending this process a few times and you can work out that the best choice would be zero. In real life, however, not everyone is so rational and the correct answer is never that low."

In essence, this is why it is nearly impossible to quantify the precise of irrationality of investors. In addition, this is also why stocks can deviate far from their underlying worth (according to price-to-earnings ratios or otherwise) for a long period of time only to quickly come crashing back to reality (the dot-com case and point). The problem for investors is that if they do not join the party on the way up (such as the rise of Nortel to $120+), there client's complain of their poorly performance compared to their competitors in the short-run. Sadly, because if this, they may not be around to see the correction (and claim victory). We all wish we could pick the peak and the trough - making money (jumping) up and down.

Thoughts, comments, and/or objections wanted.