“The wisdom of crowds has a far more important and beneficial impact on our everyday lives than we recognize, and its implications for the future are immense” James Surowiecki, The Wisdom of Crowds

Experiments in collective intelligence are happening at a faster pace than ever before. The internet is an ideal test bed for these experiments – it’s possible to collect huge numbers of opinions in real time and get instant feedback on the results. I’ve always been fascinated by this field, and in particular how it can be applied to the stock market. The application of collective intelligence to the markets is not straightforward, chiefly because the stock market is in itself a crowdsourcing mechanism. Asking the crowd opinions on a stock tends to give the same result as the market – you are (more or less) polling the same participants! This is why many attempts to beat the market through crowdsourcing have generally failed. And, it’s something that we gave a lot of thought to before embarking on our own project to create a “Smart Crowd”: StockViews.com

James Surowiecki is the authority on the Wisdom of Crowds. In his excellent book , Surowiecki explains how crowds can be more accurate than any single participant in that crowd and describes the conditions under which the wisdom of crowds is greatest. He also points towards something that I’ve always suspected myself: Conditions in financial markets aren’t all that ideal for nurturing an intelligent crowd

“Financial markets are decidedly imperfect at tapping into the collective wisdom, especially relative to other methods of doing so”

Diversity and Independence

Surowiecki explains how diversity and independence are key ingredients required for a crowd to be wise. In my experience, the stock market fails miserably on both counts.

By diversity Surowiecki is not talking about gender or ethnic diversity, but cognitive diversity – the method by which we process information. Because financial participants have been trained by academia and the CFA to think in a certain way, the stock market tends to be very homogenous in this respect. Here is what Surowiecki says on the subject of diversity:

“The positive case for diversity…is that it expands a group’s set of possible solutions and allows the group to conceptualize problems in novel ways…Homogenous groups, particularly small ones, are often victims of what psychologist Irving Janis called “group think”…Janis argued that when decision makers are much alike – in worldview and mindset – they fall prey easily to groupthink. Homogenous groups become cohesive more easily than diverse groups, and as they become more cohesive they also become more dependent on the group, more insulated from outside opinions, and therefore more convinced that the group’s judgment on important issues must be right”

This paragraph strikes a chord with me, because it describes how financial markets act much of the time. The world of Wall St analysts and CNBC news anchors is surprisingly small, and a consensus view is often reached quickly. Once that happens, there is little tolerance for independent views.

“Independence of opinion is both a crucial ingredient in collectively wise decisions and one of the hardest things to keep intact. Because diversity helps preserve that independence, it’s hard to have a collectively wise group without it”

Dependent Thinking

Surowieki explains in his book how “dependent” thinking can destroy the wisdom of a group. This kind of dependent thinking becomes prevalent when investors stop making their own estimate of a company’s value and start trying to judge what others are prepared to pay instead.   Time and time again in these situations we see the market shift towards one “consensus view”.

“Most of the time…the stock market is an ever-changing but relatively stable mix of independent and dependent decision making. Bubbles and crashes occur when the mix shifts too far in the direction of dependence”

Surowiecki characterizes these market failings as something that occurs only during bubbles and crashes. This leads back to the age-old discussion of how efficient markets are. In my experience, this kind of dependent thinking occurs much more frequently than an outsider might imagine, and it occurs at the level of the individual stock, not just at the level of the overall market.

What makes this exciting (to me anyway) is that there is a subset of the market who are constantly taking advantage of market dysfunction (and generating consistent outperformance as a result). There is strong evidence to suggest that the outperformance of these investors is not just be a matter of luck (read Excess Returns by Frederik Vanhaverbeke for a brilliant discussion of this). Almost all of these investors exhibit a strong independent streak – they are not afraid to take a view that is different to the market (indeed they profit by taking a different view). You can probably guess that investors like Warren Buffett and Seth Klarman are among their number.

How to Create a “Smart Crowd”

So in order to make crowdsourcing work, we need to isolate those independent thinkers whose opinions are more accurate than the crowd over time. We need to shift the balance of our crowd away from dependents and towards the independents. In short, we need to create a “Smart Crowd”. This is what we have done at StockViews, by selecting for participants who are consistently generating excess returns. Like any system, it isn’t perfect: Inevitably we will end up selecting some “lucky fools” – those who generated excess returns through luck, not skill. However it doesn’t have to be perfect. Our selection just needs to be smarter than what already exists in the market. And the longer the performance record of our crowd, the more confidence we can put in our selection.

In setting up the system we were guided by the following principals in order to create the right conditions to tap the wisdom of the crowd:

  1. Create a platform where communication and collaboration is encouraged, but independence of thought is maintained. (According to Surowiecki, these are the ideal conditions under which the wisdom of a crowd is manifested)
  2. An open platform, where participation is not vetted by an arbitrary process, thus maximizing diversity.
  3. An automated system for selecting the “smart crowd”, based on consistency of performance over a prolonged period.

StockViews

StockViews is an ongoing experiment in which we are trying to answer the following question: “Can we tap the wisdom of crowds in a way that is more efficient than the stock market”? I’m sure that there are many other Warren Buffetts and Seth Klarmans out there who haven’t had the opportunity to run their own fund. StockViews creates a system to isolate these minds and then combine their wisdom.

Join the conversation! 3 Comments

  1. “But they have done a miserable job of creating alpha for their clients.”
    Can you tell us how the sell-side analysts have done a miserable job?
    Thanks in advance.

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  2. I think I’d be curious to study the gray area between crowd wisdom and herd mentality. If I get lost, I’ll send up a flair.

    Liked by 1 person

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  3. Reblogged this on My Blog and commented:
    Using the power of “Group Thinking” has always fascinated me on how it can be used or abused. The following blog is along those lines.

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