Does the Market Know More Than a 6th Grader?

What was your prediction for the stock market this year? Somewhere in the 8-10% range?

While the S&P 500 Index has had an average return of about 10% since the 1920's, it surprises many to learn that the S&P 500 has NEVER had a single year return between 8-10%?

With returns fluctuating around 0% for 2015, I frequently am asked whether the market is expensive, cheap, or fairly priced. You don't have to look far to find many differing opinions on this topic. CNBC populates most of their programming with various experts weighing in with their opinions throughout the day. My answer is always, YES.

Those of you that know me probably are thinking that a flippant remark like that is not unusual, considering the source. I admit that it is at least 1% of me channeling my inner-wisenheimer, but the other 99% is due to my belief in efficient markets. 

My friends at Dimensional Fund Advisors use jelly beans to illustrate how the many different opinions of market participants collectively tend to result in the right answer. The illustration is based on an an exercise that an investment advisor uses to break the ice in presentations. The advisor shared the results of his clients' guesses of how many jelly beans were in a jar that he had on a table at the entrance to a conference. Individual guesses ranged from 409 to 5,365, but averaged out to 1,653. There were actually 1,670 jelly beans, which shows that together, we know more than we do alone. 

Recently, I had the opportunity to test this concept in real life during a visit to my daughter's orthodontist office, Z Orthodontics, in our hometown of Austin. While waiting for her appointment to conclude, I noticed a jar filled with candy corn on the receptionist's counter. Next to the jar were slips of paper that patients could log their best guess as to how many pieces of candy filled the container.

I struck up a conversation with Dr. Travis Tomblyn about the DFA candy jar and how they use it to demonstrate the power of markets. (Ironically, DFA's home office is literally right across the street from his office.) He offered to send me the results of their contest once it ran its course.

The final tally came in a few days later. The guesses ranged from 106 to 1600 pieces. Out of 112 participants, the average guess was 368. The actual number of candy corn pieces in the jar was 456.

Considering that the patients are, on average, around 12 years old, those guesses came pretty darn close. If nothing else, it lends credence to the belief that the market isn't that much smarter than a bunch of 6th graders. 

That's not to say the people making prognostications, stock picks, and managing portfolios aren't thoughtful and well reasoned. There is just scant evidence that all of those smart folks trying to outsmart one another are able to do better than the broad market over the long haul. In fact, the evidence suggests that most will under-perform the market.

So what should you do? In our opinion, you should create a portfolio of low cost index funds in an allocation that suits your risk tolerance. If you don't have the time, interest, or discipline to do that, we should get acquainted.