April 2, 2007

Wisdom of the crowds

There is a new article by michael mauboussin on wisdom of the crowds (see here). There is also a book on the same topic which I read earlier (see here). Website of the book’s author here.
The key take-away for me from the article and book has been as follows

1. The crowd is usually smarter than an individual. This means that one should discount what the experts are saying (most of the times). One should not waste time in heeding to their forecasts. It makes sense to read the insights of investment masters or good investors. One can learn from that, but stay away from forecast (especially short term) by the so called experts. Most of the personal finance websites is full of this junk. I consider it mostly as noise

2. The crowd (market) is right most of the time. What that means is that the valuation of most of the companies is right. It is not always right, but most of the time it is right. As a result if I think that the stock is undervalued and a good buy, I try to analyse my assumptions in depth and check my variant perception in more detail to be sure that I have got it right and market is wrong on it. Almost 90-95 % of times I have found that the market is right and my edge is limted to 5-10 % of the cases.

3. Be humble – One should always have a growth mindset and learn from the market and others.

4. Even if individual investors are not extremely smart, the market as a whole is smarter than the smartest individuals ( see the article and book on how this is true)

5. There are a few situations (bubbles and crashes) when the diversity and collective wisdom breaks down. In such situations, it makes sense to diverge in your thinking from the market and not be swept by the euophoria or pessimism. For ex : the dotcom boom of 2000

I would recommend reading the article and the book as it would be a great addition to one’s mental models.

Disclosure : I have no financial interest in anyone buying ,borrrowing or stealing the book. Unlike stocks, I am always happy to recommend books as there is a limited downside to these recommendations


Prem Sagar said...

Hi Rohit,
wanted to discuss fixed investments.

I had reviewed a few and most of them seem to give return below inflation or just marginally above it.

As of now, I have only in these
1. PPF (and EPF of office)
2. FMP (very marginal)
3. Floaters (all short term money)

But if u calculate post tax return, most of the fixed investments provide just around 5-6.5. The ppf is better..and so are FMPs. but are there other options that u know?

Rohit Chauhan said...

I look at fixed income options to reduce the risk in portfolio

i agree most of the options give a post tax return of 5-6%. however floaters and debt funds are more tax effecient and can give slightly better returns.

my approach in getting extra returns has been to play on the yield curve.

what that means is that if i think the rates in medium to long term will rise , i move to floaters and other short duration instruments (like FD for 1-2 years).

if i think the rates are high and close to peaking, i tend to increase the duration of my portfolio. i do that by investing in FD with slightly longer term and debt funds with longer duration.

By increasing the duration, you can capture higher returns and if the rates fall, you can net capital gains.

all this gives 1-2 % extra return. not comparable to equity , but better returns than vanilla option and with lower volatility.