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Home>UPDATE: Here's some good news for value investors

UPDATE: Here's some good news for value investors

UPDATE: Here's some good news for value investors


By Gary Smith

You can beat the market if emotions are controlled

An "efficient" stock market is a fair game in the sense that no investor can beat the market because they know something other investors don't know. The so-called efficient market hypothesis, for instance, essentially states that what anyone knows isn't worth knowing. The presumption is that stock prices take into account all information so that no investor can take advantage of other people's ignorance.

Some investors do compile outstanding records. However, consider this coin-calling experiment: Suppose there are 32 players and half predict "heads" for the first flip while half predict tails. The coin is flipped and lands heads, making the first half right. The 16 people who were right then predict a second flip, with half saying heads and the other half tails. It comes up tails and the eight who have been right twice in a row now try for a third time. Again, half of them predict heads and half tails, and the coin lands tails again.

Now the remaining four who were right divide again on whether the next flip will be heads or tails. The result is tails and we're down to two. One calls heads and the other tails. It is heads and we have our winner -- the one who correctly predicted five in a row. Are you confident that this winner will call the next five flips correctly?

Some investors surely are more skilled than lucky. Their records mostly are brief, mixed, or exaggerated, and there is no sure way to separate the talented from the lucky and the liars. The stock market is not all luck, but it is more luck than nervous investors want to hear or successful investors want to admit.

That' s because while some investors may substantially overestimate the value of a stock, other investors will err in the other direction and these errors will balance out so that the collective judgement of the crowd is close to the correct value.

The wisdom of crowds has a lot of appeal. The classic example is a jelly-bean experiment conducted by finance professor Jack Treynor. He showed 56 students a jar containing 850 jelly beans and asked them to write down how many beans they thought were in the jar. The average guess was 871, an error of just 2%. Only one student did better. This experiment has been cited as evidence that the average opinion of the value of a stock is likely to be close to the "correct" value.

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