James Surowiecki’s book, The Wisdom of Crowds, describes a classroom experiment conducted by finance professor Jack Traynor. Traynor presented a jar of jellybeans to his students and asked them to estimate the number of jellybeans in it. When he averaged the estimates, Traynor found that number to be very close to the actual contents of the jar. In fact, only one of Traynor’s 56 students came closer to the actual count than the average. Surowiecki’s book provides a number of similar anecdotes and studies to illustrate that collective errors tend to be far smaller than individual errors. Some efficient-market proponents have used Surowiecki’s work to justify their view that the only reasonable approach to investing is passive indexing. However, this view overlooks some unique attributes of asset markets that may well produce as much collective whim as wisdom.
Sometimes crowds may be wiser than most individuals, but only when certain conditions are met. In a recent presentation, Surowiecki put it this way: “The problem is that groups are only smart [collectively] when the people in them are as independent and diverse as possible. This is the paradox of the wisdom of crowds.” In the context of the stock market, diversity refers to a sort of cognitive diversity—a variety of investment styles, strategies and time horizons. Independence simply requires that people’s opinions aren’t influenced by the opinions of others. If even one of these conditions is violated, the apparent magic of aggregating opinions tends to fail, often resulting in imitative or emotional behaviors like herding, clustering or even hysteria—the whims of the crowd. It’s difficult to imagine how any market could remain consistent with these conditions for any meaningful length of time. Even the best investment strategies will experience periods of disappointment, prompting investors to follow the crowd into last year’s successful strategy. And few investors can be truly immune to the opinions of others. With asset markets often failing Surowiecki’s two basic requirements, it’s no surprise that history provides many examples of the paradox he described. Market historians call them bubbles, manias, panics or crashes.
For investors looking to exploit breakdowns in the collective wisdom, searching for extremes can be useful. Finding a stock, sector or a particular asset market that is trading outside of its normal valuation range might be a good place to start. Extreme prices require extreme expectations about the future, but we must question the reasonableness of these expectations. When evaluating the opinions of others, it’s important to maintain a perspective consistent with your overall strategy. For example, long-term stock investors should pay little attention to short-term traders attempting to guess next quarter’s earnings or next week’s news. Opportunities might exist when a lack of diversity results in short-term euphoria or concerns dominating prices.
It is always very difficult for active managers to outperform the market over meaningful periods of time, but the best hope for doing so lies not in fighting the wisdom of the crowd but in recognizing and exploiting its whims.