Crowds--Insane or Wise?

Behavioral New World

July 1, 2022

Crowds—Insane or Wise?

“Guess how many jellybeans there are in the jar.”[1] Some of you may have participated in this competition, perhaps at a state fair, with the winner getting the jellybeans and a year’s supply of fluoride toothpaste. The exercise has been repeated many times, with the same result: The average of the guesses is closer to the actual number than almost all the individual guesses. This phenomenon is referred to as the “wisdom of crowds.”

It is easy to imagine how the average (aggregate) opinion of crowds can be so accurate: Some people overestimate the number of jellybeans, some underestimate, and those errors nearly cancel out when they are averaged.

Financial markets involve crowds (of investors) and, for the most part, generate prices that are fairly accurate; that is, the prices are not systematically too high or too low. Economists refer to such markets as being “efficient.” Extensive research has shown that sports betting markets are also generally efficient—some bettors overly optimistic about the prospect of one of the teams, other bettors overly pessimistic. It all comes out in the wash.

Wait, don’t crowds sometimes get carried away in the same direction, perhaps overly optimistic or overly pessimistic? There are certainly examples from financial history to suggest that it does happen. You may have heard of Tulip Mania, which happened in Holland in the 1630s.[2] The trading of tulip bulbs became so popular that they were traded on exchanges.

One way to assess the prices of tulip bulbs is to compare them to the prices of other goods at the same time. For example, one rare tulip bulb sold for 2500 florins (the currency of Holland then) while a ton (yes, 2000 pounds) of butter sold for 100 florins. The more modern phrase, “irrational exuberance,” comes to mind.[3] Crowds can act in insane ways. Consider as another example the actions of crowds of football fans at times.

From an individual viewpoint, it is important to recognize when you might be under the influence of an insane crowd. In his book The Wisdom of Crowds, James Surowiecki describes five criteria that make for a wise crowd. For brevity, I focus on three:

1.              Diversity of opinion. I’ll have more to say about this in a future newsletter about group think and herd behavior, but the phrase is self-explanatory.

2.              Independence of opinion: An individual’s opinion is not (much) influenced by others’ opinions.

3.              Decentralization, which refers to each individual’s access to local, non-shared information. This criterion might overlap with diversity of opinion, but diversity of opinion could be about a shared information set.

Most of the time, financial markets meet these criteria and that’s why they are usually thought to be efficient as described above. But there are certainly times when, for example, independence of opinion does not hold. Investors might become collectively enamored of cryptocurrencies, leading to radical increases in price. (And when the collective sentiment changes, radical decreases in price.)

Of course, it is difficult to determine when the criteria are being sufficiently violated such that a wise crowd has morphed into an insane crowd. That is one of many reasons that the stock market is so hard to predict.

Note that a crowd does not have to be large in number. Consider the crowd consisting of your friends. There is substantial evidence that the beliefs and actions of your friends influence your beliefs and actions, a violation of “independence of opinion.” For example, you are more likely to smoke if you hang around people who smoke (likewise, drinking).

Whether in a big or small crowd, what can you do if it has the hallmarks of an insane crowd? Very briefly: guard against overconfidence, do not do something because everyone else is doing it, and ask yourself, “What if my beliefs are mistaken?”[4]  That is, you flip your belief 180 degrees, and then list reasons for why that position might be true. If any of these reasons have the ring of truth to them, they are worth investigating further.  Now that’s cool beans.

You may recall that in the March 2022 newsletter, I encouraged readers to submit either a real bias that they think exist or a fake one just for fun.  I still welcome your submissions.

Here’s this month’s from L.L.:

The Speedy Gonzales Effect: Proclaiming that other drivers should not speed even if they are running late, only to become annoyed at the slow speed of other drivers when you are late.

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[1] There are many variations on this guessing game, perhaps originally done in 1907 by Francis Galton, who asked people to guess the weight of an ox.

[2] See Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, written in 1841 (!). Some economists have argued that his account of Tulip Mania is exaggerated.

[3] Nobel Prize winner Robert Shiller’s book Irrational Exuberance made the phrase famous.

[4] You can find a more detailed discussion in my book The Foolish Corner, Chapter 5.