Financial Quick Takes: The Wisdom of Crowds vs. Popular Delusions

In a bit of a paradox, you’ll find the following two titles on our recommended reading list:

• The Wisdom of Crowds, James Surowiecki (2005)
• Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay (1852)

So, which is it? Are crowds wise or delusional? It helps to understand why the answer is yes, to
both, and why both have shaped our investment recommendations through the years.

When Crowds Are Wise

Surowiecki describes group intelligence, or the wisdom of crowds, as follows: “If you ask a large
enough group of diverse, independent people to estimate a probability, and then average those
estimates, the errors each of them makes will cancel themselves out.”

To illustrate, he shares a classic jelly bean experiment, where a group of 56 students guessed
how many jelly beans were in a jar of 850 beans. The group average was strikingly close at 871.
Only one individual guess came closer. Similar experiments have been repeated across time and
distance, and have found group consensus is consistently among the most reliable counts.
But what about those “mad” crowds? Surowiecki does not suggest every group consensus
produces remarkably accurate answers. The group must be diverse, possess “a particular kind of
decentralization,” and, importantly, be free to think independently.

Fortunately, these characteristics usually exist in free markets. Each individual trade may be spot
on or wildly off, but their average, representing all known information and lucky guesses alike,
typically generates our closest estimate to a perfect price in an imperfect world.

When Crowds Are Delusional

Of course, history is also jam-packed with times when crowds have gone bonkers, stampeding
toward outcomes no rational individual would choose.

Usually, a crowd’s rash behavior is a result of “groupthink,” or herd thinking. Surowiecki
warned against this when he wrote: “Deliberation in a groupthink setting has the disturbing effect
not of opening people’s minds but of closing them.”

Investors are exposed to the madness of crowds whenever a stock, bond, or any other tradeable
asset goes on an overwrought run or perilous plummet. When fear of missing out (FOMO), or
just plain fear overcomes a market’s usual efficiencies, a few lucky souls may profit wildly. But
billionaire businessman Warren Buffett describes the most likely eventual outcome: “[T]he stock
market serves as a relocation center at which money is moved from the active to the patient.”

Manic pricing is nothing new. When Mackay published Extraordinary Popular Delusions in
1852, he dissected several centuries-old speculative runs, including a 17 th century “tulipomania,”
when some tulip bulb trades were fetching values normally reserved for entire estates.

Until, abruptly, they weren’t. As Mackay wrote: “Enterprise, like Icarus, had soared too high,
and melted the wax of her wings; like Icarus, she had fallen into a sea, and learned, while
floundering in its waves, that her proper element was the solid ground.”

Crazy or Crafty?

Thanks to Mackay, Surowiecki, and many others, we know that group dynamics can yield
magnificently wise as well as woefully foolish results. We also know that investor “crowds”—
capital markets—can exhibit both conditions, depending on the factors at play.

Adding to the challenge, we usually only know in hindsight which type of pricing we are
participating in. Predominantly, global markets provide the volume and diverse independence
needed to generate highly efficient trades. But from tulipomania to the latest hot holdings,
groupthink can blur the view by sending securities off their proverbial rails, for years at a stretch.

Is it a bubble or substantial growth? Only time will tell.

What’s a Rational Investor To Do?

For your own investments, how do you apply the wisdom of crowds and avoid its madness?
Whether you try to outpace a wise market or a delusional one, you’re far more likely to be beaten
by the crowd than to outsmart it. Under these circumstances, your best bet is to:

Would you like to know more? Reach out to us today for a personalized conversation
about your investment portfolio.