Communicating difficult financial concepts is rarely easy, and it often works better if you drop the obscure jargon completely and tell the story using an analogy or metaphor.
With that in mind, TEBI is pleased to present a new regular feature called Look at it this way, which aims to reorient often arcane financial or money-based ideas in a visually arresting and more familiar way.
An important concept that many investors struggle with is the idea that financial markets are highly competitive and that prices are the best estimate we have of future returns.
That may be because much of the financial media is built on the assumption that you can profit consistently from mistakes in share prices, despite the mountain of research showing that even the professionals struggle to do that.
One response to that is to talk about the wisdom of crowds. Remember that TV show, Who Wants to be a Millionaire? Contestants stumped for an answer are given three lifelines — 50/50 (two choices), phone a friend, or ask the audience.
According to author James Surowiecki, phoning a friend will give you the right answer about two thirds of the time — better than the 50/50 option. But asking the audience yields the right answer more than 90% of the time.
Accepting market prices is like asking the audience. They’re never going to be perfectly right, but it’s the best barometer we’ve got. And by not trying to work it out all on your own, you’re freed up to focus on all the things you can control.
A marketplace aggregates lots and lots of information very efficiently. The TV studio audience in this case is like all those buyers and sellers in the share market. No single person has got all the information, but together the wisdom of crowds can get close to the truth. In investing, that truth is reflected in the price.