Hi Guys,
Well is it the wisdom or the madness of the crowds? From a literary world perspective that would depend upon whether you are reading James Surwiecki’s “The Wisdom of the Crowds” or Charles MacKay’s “Extraordinary Popular Delusions and the Madness of the Crowds”. Probably both are representative of reality, partially dependent on history, on international tensions, on exogenous events, on endogenous happenings, and on personal perceptions, both real and imaginary.
We are surely susceptible to manias and bubbles, to fear and greed that shape our decision making. Since that’s the case, a reasonable extension of that observation is that the financial marketplace has no prospect of coming close to rational behavior. Maybe, maybe not.
We have all heard the axiom that “None of us are as smart as all of us”. That truism has been demonstrated many times over when expert panels with diverse backgrounds are assembled, and isolated from each other to retain freedom to think and act independently, to grapple with complex problems and issues that defy recognizable solutions. As a general outcome, the group’s average solution is superior to any individual’s preferred approach. I personally have participated on such panels and have shared the group’s success.
There is a very important distinction between a group’s opinion, and an individual’s proposal. The group can be more than the sum of its parts.
In his book “More Than We Know”, Michael Mauboussin explores this dilemma with a syllogism as follows:
“Humans are irrational
Markets are made up of humans
Markets are irrational.”
Given the validity of the two opening assertions, the third statement must decisively ensue. Even if the two assertions were absolute truths, which is not necessarily so since humans are rational some of the time and market decisions are sometimes completed with computer-driven tactics and trades, the concluding statement is not infallible.
Mauboussin summarizes his point with the succinct claim that “Markets can still be rational when investors are individually irrational”.
If there is sufficient independent analyses, goals, timeframes, and perspective interpretations, the diversity of the final judgments tend to cancel each other out. The market consensus can be far more accurate and perceptive than any single guru’s viewpoint. The herd gets it right until it becomes too uniform in its assessments and stampedes in the wealth destroying direction.
Mauboussin concludes his brief article with the observation that “The key to successful contrarian investing is focus on the folly of the many, not the few.”
One implementation difficulty of a contrarian’s style is to identify a reliable measure of the crowds average position. One candidate gauge is the American Association of Individual Investors (AAII) Sentiment Indicator. Tens of thousands of small investors volunteer in this statistically impressive survey. And it is updated weekly in the AAII website at:
http://www.aaii.com/sentimentsurveyYou may recall that I included the AAII Sentiment Indicator as one component in my six-factor Retirement Equity Assessment Model (REAM). The six components of the model are: (1) Fiscal, (2) Momentum, (3) Valuation, (4) Microeconomics, (5) Liquidity, and (6) Sentiment. I mostly included the AAII sentiment signal because of its exhaustive nature, its frequent updates, and its easy access.
However, how accurate is its opinions with regard to future market movements? Can it reliably indicate market future returns for the upcoming year? The AAII Sentiment Indicator survey has been conducted for many years; it has a track record. So it can be stress tested against future market returns like the S&P 500. That has been done.
Let’s examine its historical record as a forecasting predictor. Here are two excellent summary articles prepared by organizational AAII members themselves. I have provided Links to both of them. The first reference is a 2010 update of an original assessment published in 2004; the second reference is to the original study authored by Wayne Thorp. The 2010 update has imbedded the 2004 study in its entirety. I recommend you read the original paper because the plots are nicely integrated within the text so the reading is more easily completed.
http://www.aaii.com/journal/sentimentsurveyarticlehttp://www.aaii.com/files/sentimentCIfeature.pdfThese references document the usefulness of the AAII Sentiment Indicator as a contrarian’s signal. Enjoy. Wayne Thorp concluded that “If you run with the herd, you might get trampled.”
I posted on this topic now because the AAII Sentiment Indicator has recently migrated into dangerous waters. I assess its current status as in my cautionary yellow zone. Although the current AAII Bullish sentiment is slightly above its historic average, it has not yet become sufficiently bullish to warrant an action.
Thorp’s paper suggests that a bullish signal of at least one standard deviation above its historic average needs to be registered before it is actionable as a contrarian’s sell signal. If you subscribe to that interpretation, then the AAII bullish sentiment must reach a level of about 50 % to deliver a contrarian’s sell signal. In preparation, the red flag has been unsheathed, but is not yet waving.
I do NOT dogmatically follow these signals; I use them in a guidance sense, and then only incrementally. Any mechanical rule should not replace common sense and should be deployed judiciously.
Most market wizards use a far more complex array of market signals when establishing their forecasts on market direction and portfolio asset allocations. James Stack, founder and chief designer of his InvesTech methods, has publicly acknowledged that he uses over 200 common and specially constructed signal generators. Each man chooses his own poison or his own poison concoction if he’s a more sophisticated market student (results will still be uncertain).
Because of my long standing distrust of all mechanical investment schemes, my incremental approach even after making an investment decision, and the marginal penetration of my AAII Sentiment Indicator, I have NOT taken any action with regard to my current portfolio asset allocations. That Indicator does bear careful monitoring because of its trending.
I wish you all continuing investment prosperity. But current market conditions demand constant vigilance. I am much worried over the entire globe’s financial status. Prompted by these concerns, I’m rereading Charles Kindleberger’s book “Manias, Panics, and Crashes”. It is not an easy task since it assumes the reader is familiar with distant and minor market crises.
However, Kindleberger’s classic does capture the significant characteristics of these disastrous historical events and parallels with current market conditions. It warns of the dangers of foreign contagion; it warns of inflation encouraged by excessive money supply growth; it warns of housing and equity bubbles that are promoted by unrestricted credit exposure. All these cautionary warnings seem applicable today; we are forewarned. So take care by taking prudent and controlled risks.
Best Regards.
Comments
It becomes "wisdom of crowds" if the "opinions" rendered are independent. That is each individual is not aware of other opinions and other individuals. This is a very rare situation in investing as much of the opinions are disseminated publicly and another decision maker is often "contaminated" and is not really rendering an independent verdict.
It becomes "madness of crowds" if we lose this independence and herd behavior takes place and herd is steered by dominant characters. For example, this is a very common issue with analyst ratings of the corporations.