Charlie Munger once told a story about a rural school in Texas where a teacher asked a question, “If there are nine sheep in a pen and one jumps out, how many are left?”
Everybody got the answer right except this little boy, who said, “None of them are left.”
The teacher laughed. “You don’t understand arithmetic.”
The little boy said, “No, teacher. You don’t understand sheep.”
This herding behavior unfortunately isn’t exclusive to sheep. Humans succumb to it as well.
Research though shows that groups in general tend to make better decisions than individuals. When different points of view analyze a given piece of information, the collective opinion of all improves decision making with that information. This is evident if you watch the TV show Who Wants To Be A Millionaire when contestants use the audience poll lifeline, the crowd’s answer is more times right than wrong.
This wisdom of crowd is best illustrated in the economy by the free market price system where millions of individual decisions by consumers and producers through Adam Smith’s “invisible hand” makes the economy produce just the right goods in the right quantities at the right time. Centrally planned economies on the other hand can never match the efficiency of the free market system in determining what to produce and how to best allocate resources.
Because without the real-time feedback provided by prices and individual choices, centralized economies often misjudge demand, leading to shortages, surpluses, and widespread inefficiencies. These systems eventually fail.
On the stock market front, millions of individual and institutional investors, through their collective buying and selling, help set stock prices that appear to make one stock just as good of a buy as another. Though prices are not always right, they are systematically more right than the forecasts made by any individual investor.
But sometimes instead of the wisdom of crowd setting prices, the madness of crowd takes over as we have occasionally seen from the seventeenth century tulip bulbs to the twenty-first century mania with internet stocks.
Manias often coincide with technological breakthroughs be it the invention of the steam engine, the railroad, the electricity, the automobile, the computer or the internet. Early participants get rich which invites a flood of new entrants and very soon, people invest for no other reason except that the price is rising even when that price could not be justifiable by any fundamental means. At some point, this whole mechanism starts to resemble a Ponzi-like situation where more and more investors must be found to buy the stock from the earlier investors. Eventually, one runs out of greater fools and the whole thing crashes back down to reality.
The consistent losers in the market are those who are unable to resist the temptation to participate in these speculative binges. And the temptation is strong at the peak of these binges because imagine the sight of your dumb neighbor getting rich on some equally dumb investment.
Yet, one can sidestep some of the madness using common sense valuation logic but the ones that coincide with technological breakthroughs are hard to analyze and hence price. Because one can contort the inputs to the intrinsic value calculation for a business anyhow one wants and be able to justify any possible price. Only in hindsight would we know if the price was right or wrong.
Some exposure to bubbles hence is warranted just by the nature of us being willing participants in the capital markets. But keeping a balanced exposure to all corners of the market while properly calibrating one’s time horizon is how we avoid a bubble bursting from derailing our long-range plans.
In the end, it is not perfect timing that builds wealth. We build wealth through good planning and disciplined execution over and over and over again.
Thank you for your time.
Cover image credit – Jonathan Borba, Pexels