Crowd behaviour is often thought of as irrational. We associate it with mobs, cults and a tendency to panic or adopt a herd mentality, often to ill effect. Yet not all crowd behaviour is negative, as Sir Francis Galton found at a farmer's fair in Plymouth in 1906 where he asked 787 villagers to correctly guess the weight of a slaughtered ox. While no exact individual guess was made, the collective average of estimates came to within one percent of the true weight.
This phenomenon, now-well established and known as the wisdom of the crowd, is the idea that the collective opinion of a group can be better than a single expert opinion provided the crowd does not influence itself. It clearly shows that the democracy of thought can produce results worth considering.
Today there are countless examples of the phenomenon put to practical use. Google, for example, will send pages higher up the search rankings if more people are linking to the page due to its popularity. Another immediately recognisable example is asking the audience on Who Wants to Be a Millionaire. The player usually takes the answer most popular with the crowd and, in 95% of cases, it will be correct. Perhaps unsurprisingly this method has long been applied to investments.
Grey markets which allow investors to speculate on a company ahead of its official IPO opening day are a great example of this. By looking at the extent to which those trading on these markets are going long or short on a company ahead of their listing, you can gain an indication of what the market thinks of a company before it has even listed.
Last year we ran grey markets on both the Royal Mail and Twitter IPOs which were more accurate in predicting prices than bankers and their advisers. On the Twitter IPO, the grey market predicted that shares at the end of first day of trading would be worth $44. They actually ended up at $45.06 - incredibly close - particularly when you consider that the price set by Twitter and the bankers was $26.
How does this work?
Upcoming IPOs generate noise from the media, financial institutions, analysts, retail investors and anyone else with an interest in the company, forming a spread of opinions which can influence investors on IPO day.
However, one of the reasons that grey markets are becoming an increasingly popular tool amongst investors to help estimate pricings is that they rely upon the thoughts and opinions of those who are actually prepared to take a financial position on a company, people who are willing to put their money where their mouth is.
Growth in grey markets
The large number of high-profile IPOs taking place has led to more people becoming interested in how they can potentially profit from them as part of their wider wealth management strategy. In the UK retail sector alone we have seen the likes of Poundland, Pets at Home and AO.com all list this year and there a number of other big names on the way such as Alibaba.
And here it's worth pointing out an additional attraction of grey markets. Recently, we've seen a number of companies; including online takeaway service JUST EAT, say that they will exclude retail investors from any listing and only offer shares to institutional investors. This means that even if you know a company well and want to invest, you can't as a retail investor. Contrastingly grey markets are open to all and consequently offer a way to get involved in the action.
Nothing is certain
Of course, grey market ‘predictions' aren't always right and it would be wrong to suggest otherwise. However they do provide another indicator, based on the wisdom of the crowd of those actually investing rather than just analysis, and that in itself is valuable.
