Have you ever entered a jelly bean contest, where you try to guess the number of jelly beans in a jar? An interesting thing happens when you take the average of all the guesses.
Jack Traynor did exactly that. He brought a jar of beans (not the jelly kind) into two classes and asked the students to guess the number of beans inside. So the students crowded around the jar. They tried to count the beans or estimate the beans per volume or other such things to come up with their best guess. Then they wrote down their guesses and turned them in.
Traynor found that in both classes the average of the guesses came very close to the actual number of beans. But what really stood out was that the average of the guesses beat all but one or two guesses. In other words, only one or two students actually did better than the average of the whole group.
This effect is known as the wisdom of crowds, but it requires a key ingredient:
These results suggest that, in situations where the subjects have not been schooled in a “correct” approach, the bulk of the individual errors will be independent, rather than shared. Apparently it doesn’t take knowledge of beans, jars or packing factors for a group of students to make an accurate estimate of the number of beans in a jar. All it takes is independence.
A crowd of bean guessers can be highly intelligent as a whole, and often smarter than the smartest participants among them, so long as their guesses remain independent.
Now replace beans with stocks and you get a sense of how the stock market works. As a collective, market participants’ guesses on asset prices come remarkably close to the true value.
It’s not perfectly accurate, of course. Instead, the prices are close enough that little to no opportunity exists to earn a higher return (in most cases). Put simply, opportunity is priced out. So, in most cases, buying the market will get you returns similar to the growth of the underlying businesses over time and nothing more.
Of course, this is why the market is hard to beat and why owning the market is recommended for so many investors.
Except, it’s not perfect. Inefficiencies exist that create opportunities. Treynor calls it shared errors.
Independent errors (wrong guesses) happen in a large pool of bean guessers. So long as the pool is diverse and the guesses stay independent, the randomness averages out to a collectively great guess. But shared errors turn the wisdom of crowds into a biased mess.
Traynor tested this with a second experiment — after recording the first guess — by “warning” students with two bits of misinformation: there was air space at the top of the jar and the jar walls were thinner than normal.
It turns out that the new information skewed the average result enough to be worse than the original average guess by a factor of four. Traynor likened it to how published research might sway many guesses on a stock price.
Of course, research is just the tip of the iceberg for what might sway guesses.
Joel Greenblatt offered a simpler example of how shared error works using a tastier jelly bean test. Greenblatt twice asked a class of ninth-graders how many jelly beans were in a jar.
The first time, he asked the students to write down their guesses on an index card. After everyone turned in their card, he asked them again. Only this time they could keep their first guess or change it but had to give their answer out loud.
The results speak for themselves. The kids, upon hearing their classmates’ guesses, collectively changed their answers for the worse.
The average of the first guess, written on the cards, was off by 5 jelly beans. But the average of the second guess, announced out loud, fell to roughly half the actual number of jelly beans. Greenblatt explained it like this:
I explained to them, the stock market is actually the second guess. Okay? Because everyone knows what they just read in the paper or what the guy next to them said or what’s on the news and are influenced by everything around them. And that was the second guess and that’s the stock market.
The cold calculating guess, when they were counting rows and trying to figure out what was going on, that actually was the better guess. That’s not the stock market, but that’s where I see our opportunity.
It’s a simple example of how easily shared errors — biases — can be injected into market prices. Opportunities exist for this reason.
However, the difficulty is in recognizing the opportunities. If every ninth-grader who changed their answer for the worse believed it was for the better, how often do investors make a similarly biased decision?
And it doesn’t take much to sway decisions. Something as basic as knowing a stock’s recent performance can influence an investor’s guess. This is why Buffett only looks at a stock’s price after he’s finished with a valuation.
So independent thinking is key. Your guesses have to be unbiased.
But because the crowd is often right, your guesses not only have to be good enough to know when the crowd is wrong but wrong by a wide enough margin to potentially earn a market-beating return.
Finally, you have to act on it. Because if you can’t bet against the crowd, being the most accurate guesser won’t matter.
This post was originally published on February 7, 2020.
Market Efficiency and the Bean Jar Experiment