The 2-Minute Thought: When the Wisdom of Crowds Doesn’t Work

 

The wisdom of crowds is the idea that the judgment of a large group of people can be better than that of any individual.  If you ask a large enough group of people to guess how many jelly beans are in a jar, the average answer will be remarkably accurate and better than most of the individual guesses. 

James Surowiecki’s 2004 book, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations, popularized the idea.  The opening story is about how ordinary people attending an English county fair in 1906 collectively did remarkably well at guessing the weight of an ox.  The average of all the guesses made by fair-goers was not only better than most of the individual guesses.  It also was better than all the estimates made by cattle experts.   

That is one of the fascinations with the wisdom of crowds:  Experts can be very wrong.  Yet ordinary people who are not particularly well informed can be quite right, collectively.  And that holds regardless of how eccentric or idiosyncratic any single individual’s ideas may be (provided the crowd is large enough).

But crowds certainly are not always smart.  We all know of examples when crowd thinking can be a disaster (see the classic New Yorker cartoon above).

For the wisdom of crowds to prevail, four conditions must hold:

  •         There must be a diversity of opinions. 
  •         There must be independence among opinions -- meaning that individual opinions should not be influenced by other people’s opinions. 
  •         There must be decentralization -- meaning that people can call on their own specialized or local knowledge in formulating an opinion.
  •         Finally, there must be some kind of aggregating mechanism for turning everyone’s opinion into a collective one.

Markets usually get identified as being a wonderful aggregating mechanism, and they are.  By bringing together buyers and sellers, they are able to express a whole crowd’s opinion in the form of price.  But in financial markets, the crowd does not always get it right.  We know from the financial history of bubbles and manias that the wisdom of crowds can turn into the madness of crowds.

Where financial markets often fail is in diversity and independence of opinion.  Investors herd.  Instead of behaving differently, they choose the warmth of the crowd by doing what everyone else is doing.  That is how prices can get to be so wrong. 

Researchers in Switzerland once asked a large group of people to guess at things like the length of the border between Switzerland and Italy or the number of murders in Switzerland each year.  As the participants were allowed to learn more and more about what other people were guessing, the range of their estimates got narrower and drifted farther away from accuracy. 

That can happen to earnings estimates too.

The lesson for investors isn’t to always embrace contrarian opinion.  It is to go beyond the opinion that’s easy to have.  It is to seek out views that don’t match one’s own.  It is to think about the full range of possible views every time we buy and sell.