by Archie M. Richards, Jr., CFP^®
January 19, 2004

Don't try to buy or sell investments on the basis of current news. You'll be too late. Markets are more in touch with reality than any of the participants. Here's evidence:

Jack Treynor, inventor of the Treynor Method of evaluating risk, is a prominent expert on finance and markets. As an experiment, he placed 850 jelly beans in a glass jar and asked a class of 56 students to estimate the number of beans. The guesses varied widely. But the average of 871 was just 2.5 percent off the correct number of 850. Only one student's guess was closer than the average.

Collective guesses are generally more accurate than those of any of the individual participants. The more participants, the more accurate the market. At an agriculture exhibition in England in 1907, for example, 787 people each bet sixpenny on the weight of an ox. The person with the closest bet received the money. The ox's actual weight was 1198 pounds. The average guess was only one pound off: 1197 pounds.

The University of Iowa organizes futures markets based on the outcome of U.S. elections. Since 1988, the Iowa Electronic Markets have been more accurate than national polls 75 percent of the time. To participate yourself, see www.biz.uiowa.edu.

Traders on the Hollywood Stock Exchange (hsx.com) have consistently provided better predictions than industry forecasts of box office returns during opening weekends.

Millions of people from all over the world participate in U.S. stock markets. Some are knowledgeable. Others may know nothing about stocks but contribute money to a 401(k) plan invested in stocks. Still others are too apprehensive to buy stocks at all, making the prices lower than if they did participate. Both the participants and non-participants have opinions about the future prospects for particular companies and the economy. No individual predicts the future accurately. But the collective guesses are usually pretty close.

We can't ask the participants to express their views. Too many people are involved, and many of the views are too subjective to be stated clearly. The only way we can know the predictions is to note the prices of the stocks. The stock market is a giant voting machine about the future.

Markets predict the future successfully as long as the guesses are independent of each other. If the students in Jack Treynor's class had been made aware of the estimates of other students and skewed their guesses according to what they thought was the trend, the bandwagon effect would have rendered the average guess well off the mark.

In 1999, the U.S. stock market suffered a bandwagon effect. Many investors wanted to own large growth stocks because everyone else wanted to own large growth stocks. Therefore, the high prices of growth stocks in early-2000 did not reflect the future accurately.

I recently called Jack Treynor. (We're old friends.) I said, "Jack, most investment experts believe that stock prices anticipate earnings by something like 4-to-6 months. Do you agree?"

Jack said, "I do."

I continued. "I believe that stock prices generally anticipate all business news by something like 4-to-6 months. Do you agree with this?"

"I do," he said.

Finally, I said, "Stock prices also react to current news, of course. But unless the price trend of the short-term reaction is in accordance with the character of news that won't become known for 4-to-6 months, the short-term reaction doesn't persist. The market instead reverts to predicting the future. Do you agree with that?"

Jack responded, "I do agree. And you know, I've never heard anyone say this before."

You, dear reader, now have two propositions on which you can rely:

1. By the time financial news comes out, it's too late to buy or sell on the basis of the news. Markets predictions are usually more accurate than those of any of the participants.

2. Stock prices react to current news. But unless the reactive trend reflects the character of news that won't become known for months, the short-term reaction doesn't stick.

As to that second proposition, you heard it here first.