When the wisdom of the crowd isn’t that wise…

This summer saw aggressive dips and spikes in equity markets. I believe passive investing is a factor in these wild swings. Market mechanics are complex, but these moves can be explained with the help of some bean counters.

Imagine you are at a country fete and there is a competition to guess how many jelly beans there are in a large jar. A hundred people join in the game.

Some spend a lot of time walking around the jar, holding it, estimating the volume of a bean relative to the volume of the jar. They get out their phones and open the calculator app. Others just take a wild guess – 100, 237, 301.

There is sufficient diversity of opinion to mean that the average guess will be closer to the number of the jelly beans than most individual guesses. The average guess from all these ‘actors’ represents what is dubbed ‘the wisdom of the crowd’.

Eventually, Ted the groundsman – who is a bit of a maths wizard in his spare time – works out that there is no point trying to guess. He will take the average number and just follow that.

There is a flaw in his plan. It assumes people are logical. There are some circumstances that might influence the crowd – they may have all been to the beer tent first, for instance. But, as they learn about Ted’s strategy, more people start doing the same. Soon half the room are ‘followers’ rather than ‘actors’.

At this point, the diversity of your population starts to break down. The average becomes more sensitive to the extreme calls. The crowd has essentially become dumb.

Crowded trades

This, to some degree, is what has happened in markets. According to Morningstar, the total assets under management in exchange-traded funds and notes along with passively managed mutual funds reached $13.29 trillion at the end of 2023 – just above the $13.23 trillion held in active assets¹.

It means fewer participants now have an interest in arbitraging the difference between the price and the fundamentals. They are just going with the predominant view, and this is subject to wild mood swings and the influence of a small number of big players.

To understand these swings, we perhaps need to introduce a different analogy. On 10 June 2000, the Millennium Bridge opened across the River Thames at St Paul’s. But within a few hours it was swaying so much it had made many of the 90,000 people who crossed it dizzy, earning it the nickname ‘Wibbly Wobbly’ and forcing its temporary closure.

The problem was not wind or the river flow. It was the pedestrians. There is a curious positive-feedback phenomenon known as synchronous lateral excitation. Most of us have a natural sway motion as we walk. This caused small oscillations in the bridge. But then, instinctively, people began walking in step with the sway and with each other. This only increased the amplitude of the bridge oscillations.

Positive feedback

And there you have it. Everyone gets excited about AI. Active investors focus on a few big players, the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla). The price of these shares goes up. Passive investors automatically join in step, the price goes up further, and before you know it…

The appreciation of those seven stocks was responsible for more than half of the S&P 500’s gain of 26.3% last year. The top 10 stocks now represent 28% of the US market – it was just 14% a decade ago, according to Morgan Stanley².

Performance of ‘Magnificent Seven’* vs S&P 500 31/12/2022 – 31/12/2023

The downs can be just as dramatic. Investors suddenly realise how top-heavy things have become. Something triggers a correction – for instance, Google’s managing director Sundar Pichai sharing disappointing results and raising doubts about whether the investment in AI will generate the sort of returns people are now expecting. Or Tesla reporting a 45% drop in profits³.

Selling sends the price down, and passive investors again fall in step – amplifying the impact. In 10 trading sessions, the Magnificent Seven lost a combined record $1.75 trillion of market cap in August⁴.

Being an active investor in these kinds of markets can be difficult. When the market is this concentrated and valuations at the top become inevitably stretched beyond reason, the active investor will be underweight these stocks. History shows that the top stock is typically a poor investment⁵. But for a long time, active managers can look foolish – until the mood swings. I suspect European managers underweight Nokia at the turn of the millennium when it was about two-thirds of the Finnish stock market felt pretty stupid⁶. Not today.

Active managers can look foolish – until the mood swings. I suspect European managers underweight Nokia at the turn of the millennium when it was about two-thirds of the Finnish stock market felt pretty stupid. Not today.

When the tide goes out…

That last illustration comes from an era before passives became popular. This concentration is not a unique phenomenon – but the speed at which it has built is. It does underline the point that active managers are not necessarily the heroes in this story. I do not deny that there are many poor active managers out there who do not deserve their fees.

But I also believe the heroes will necessarily be found in the active camp.

Active will show its value when the broader tide goes out – and I do believe that will be the case with the cycle ahead of us.

Good managers with a focus on fundamental value will ultimately outperform – and this sort of volatility gives them more opportunity to do so. You just have to find these good managers. That was always the challenge.

The difference now is perhaps that, with markets behaving so irrationally, you might be required to show more patience and trust in these managers than before. There may be long spells when their performance looks poor – where their actions to mitigate the hidden risks of mispricing go unrewarded – but eventually I believe you will be glad you did.