M&M Theory

The day I first started learning about Modern Portfolio Theory and the Efficient Market Hypothesis I was sitting across the desk from Joe Madden, the President of Madden Funds Management, exploring the possibility of joining the Madden team. The pleasantries were behind us and we were now ready for a more substantive discussion. Joe contemplated for a moment, searching for the best way to unveil the fundamentals of their strategy to me. I'll never forget the four words he chose to start the conversation: "Brendan, markets are efficient."

Now, I have a background in statistics. I've studied and taught the subject. I had also used statistics in my professional career up to this moment, so his statement had a particular resonance with me. It took some time for me to more fully grasp the nuances of the strategy, but it was at that moment I realized I had been examining investing through an incorrect lens. This new lens made much more sense. Since then, I've been looking for ways to demonstrate why I believe the market is efficient, or at least highly efficient.

The answer: M&M Theory

At a previous employer, I was lucky enough to work under a truly gifted manager. One of his talents was building highly functioning teams. On the first morning of a 5-day sales training session, this manager began by placing a large glass bottle full of M&M's on the table in front of a staff of about 60 people. He asked each of us to make a guess sometime during the first 4 days as to how many M&M's were in the bottle. There were obviously hundreds.....

I think I was the only one who took a scientific approach to the problem. Apparently M&M's have a well designed shape in which they are able to occupy a great deal of the volume, leaving very little empty space. It has to do with the variety of possible orientations in which they can be situated. I found a university study on the Internet that examined the number of M&M's per unit of volume. The study came complete with an equation for me to use......all I needed was a value for volume. Fortunately, the bottle in question had the volume figure on the bottom, so I was able to confidently make my guess: 789

On the 5th day of the sales training it was revealed that the actual number of M&M's in the bottle was 782. I was happy with the result, but there was another closer guess. One of my colleagues had guessed 787. I asked him about it and he said he was just lucky and that he had simply guessed.

As I was an analyst for the business, my manager asked me to take all 60 guesses and calculate the average. The average was 784. Not only was the average of all the guesses only 2 away from the correct answer, it was closer than any individual guess. The point of the exercise was to demonstrate that as a group we were smarter than any one of us individually.

You might now be asking yourself, "What does this have to do with investing?"

In this example, the bottle of M&M's represents the true value of a company stock and the 60 people guessing represents the broad market of stock investors.

Let's take into consideration how the price of a single stock is determined. Imagine all the public information widely available and free flowing to investors this day in age. It's immense. Investors as a group take all the available information and begin to trade depending upon their evaluation of the value of a stock. In the first 3 months of 2008, The New York Stock Exchange reported 654.4 million trades across the 2,805 listed companies. This breaks down to about 3,762 trades per listed company per trading day. It is the buy/sell decisions of the investors on both sides of these trades that determine the price of a stock at any given moment.

It's important to note that for every seller there must be a buyer and visa versa. There is an equilibrium reached between the two groups. When new information becomes available (i.e. a new earnings report) this new information is quickly incorporated into the stock price as it again achieves equilibrium. So if a stock is valued at $10 dollars a share today, that value was determined by the investor group as a whole.....like the average guess of M&M's in the bottle, except on a much grander scale.

Hare investors are of the mindset that if they do enough research they will be able to capitalize on stock 'mispricings'. Essentially they believe that the market has inefficiencies that they would be able to use to their advantage. They may look at the stock valued at $10 a share and say, "I think it's really worth $12 a share." So they buy the stock. What they are really saying is, "I'm smarter than the thousands of other investors who have already collectively made their opinion known that the stock is correctly valued at $10 a share.

Tortoise investors believe that the market is highly efficient and that they would be better served working with the market as opposed to digging around to find situations where the market got it wrong.

Think of it this way, if you had to make the decision to guess every day for the next 30 years as to how many hundreds of M&M's were in a bottle where the number changed daily or alternatively accept the average guess of a large number of participants everyday for the next 30 years, which would you choose?