Short-term emotion, long-term value
Sir Francis Galton was one of those eminent Victorians who seemed capable of turning their hand to almost anything. Explorer, scientist, and statistician, he is famous for the anecdote about the country fair, where attendees were invited to guess the weight of an ox. Individual estimates varied wildly, yet the average proved remarkably close to the animal’s actual weight. The observation eventually inspired the idea of the “wisdom of crowds”: while individuals may be prone to error, large groups can collectively produce surprisingly accurate judgements.
If crowds are so wise, why are share prices so volatile? Markets often react sharply to events, only to reverse course days later. The conflict between the US and Iran is a pertinent example. Geopolitical shocks, economic data releases and company announcements can trigger abrupt moves, yet markets often recover or change direction just as quickly. Equally puzzling, prices frequently move throughout the day without any obvious news at all. If collective judgement is generally accurate, why do share prices appear so unstable?
Nobel Prize winner Professor Robert Shiller was among the first economists to demonstrate that stock prices were more volatile than could easily be justified. In simple terms, his starting point was to argue that the price of any share is sensitive to long-term interest rates. If interest rates fall, deposits and bonds become less attractive relative to equities, while rising rates have the opposite effect. Small changes in long-term rate expectations can therefore have a large impact on valuations.
Another part of Shiller’s explanation is that a share price reflects the present value of all future dividends and buybacks investors expect to receive. Any change in expectations around sales, costs, or profit margins therefore affects valuations as investors continually reassess a company’s long-term earning power. Company profit warnings and dividend cuts often lead to sharp falls in share prices as investors reassess the company’s long-term prospects. Conversely, unexpectedly strong results can drive rapid gains, as seen recently with companies such as Nvidia.
Professor Shiller examined stock prices, interest rates and dividend expectations, and concluded that markets were more volatile than these factors alone could explain. His findings challenged the idea that markets are fully efficient, pointing instead to a force beyond these fundamentals: emotion.
Shiller’s great insight was that investors could sometimes collectively succumb to irrational exuberance, challenging both the wisdom of crowds and the efficient markets hypothesis. Shiller became one of the leading figures in behavioural finance, helping bring ideas such as herding, overconfidence, and investor psychology into mainstream investment analysis.
These insights seem obvious today to anyone who has seen the activity around GameStop’s share price or the bewildering rise of crypto and non-fungible tokens. The wisdom of crowds was not wrong, but it relied on participants making independent judgements. As we have seen in recent years, social media can weaken that independence by encouraging herding, amplifying emotion and reinforcing extreme narratives.
How should an investor react to the idea that there is more volatility in the market than is justified, and that social media may be making it worse? The first step is deciding on a good investment strategy and sticking to it. This sounds obvious, but we are emotional beings and we all need to learn the investment superpower of patience. Another step, which helps us learn patience, is to be prepared for the downside. Understand the pain you might suffer in the market, and how long it might last for – sometimes it can be years.
In a diversified portfolio, it is both rare and undesirable for every holding to rise simultaneously. Different assets perform well at different times, and investors must be willing to tolerate periods when parts of the portfolio lag behind.
The apparent contradiction between Galton’s wisdom of the crowds and Shiller’s irrational exuberance can be reconciled by recognising the importance of time. Over the long term, the independent judgements of millions of investors tend to push prices towards intrinsic value. Over shorter periods, however, herding, overconfidence and emotion can dominate, particularly when amplified by modern media. This is why Benjamin Graham’s famous observation remains so apt: in the short term the market is a voting machine, but in the long term it is a weighing machine. Successful investors understand the difference.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
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