|When you’re looking for insight, it’s natural to seek out people who know what we don’t. The investment world in particular is full of experts. The financial news has an endless stream of experts offering stock market analysis and predictions.
Experts are everywhere. But even experts aren’t as smart as the group of “everybody.”
The reality is that groups of people are smarter, and make better predictions, than individual experts or anyone else. Ask a large number of people to predict the outcome of an event, and the average prediction consistently beats that of individual experts. This “wisdom of the crowds” is increasingly used as the basis for a growing number of businesses and prediction services.
The wisdom of the crowds – proven by an ox
The remarkable intelligence of groups was first discovered by British scientist Francis Galton, a 19th century British explorer, anthropologist and statistician. Among his many contributions to science were formulating the concepts of correlation and reversion to the mean. Less admirably, Galton was also one of the pioneers of “eugenics” – a social movement that sought to improve the genetic composition of the human race through selective breeding.
Simply put, Galton believed that most people weren’t that bright. So, one day in the fall of 1906 while visiting a county fair, Galton thought of an experiment to confirm his negative opinion of the common person’s intelligence.
At the fair, Galton came across a competition to judge how much a fat ox weighed. Those whose guesses came closest to the ox’s actual weight would receive a prize. Eight hundred people placed bets. This included a few livestock experts, but most of the people betting couldn’t even tell an ox from a cow.
The Devon working ox
After the event, Galton collected all the tickets, to calculate the mean(or average) of the group’s guesses. The mean would represent the collective wisdom of the crowd.
Galton presumed that the average guess of the ox’s weight would be way off the mark. He expected that mixing the estimates of a few smart people with the guesses of less informed people would result in a poor estimate. But he was wrong. The crowd’s estimate was nearly perfect – their guess was off by just one pound.
Galton had discovered that groups are highly intelligent – often smarter than the smartest people in the group. The scientist was forced to change his opinion of the common man’s collective intelligence.
How wisdom of the crowds is used today
Today, the wisdom of crowds is the basis for a growing number of technologies. Google doesn’t ask an expert what webpage is best for your search – it tracks what everybody else is looking at on the topic. While old-school encyclopedias are written by experts, Wikipedia relies on the collective wisdom of the crowd to write about topics.
Several startup companies analyse Twitter and other social-media feeds seeking to tap the wisdom of crowds for stock picks. Recent studies have linked positive tweets about a company with its short-term price performance.
One of the longest-running uses of the wisdom of crowds has been to predict elections. Since 1988, the Iowa Electronic Markets have allowed small-scale betting on the outcomes of various U.S. elections. This so-called “prediction market” has done very well forecasting various elections – better than pollsters, in fact.
As an example of how it works, bettors can now buy a Democrat (Hillary Clinton) share for 77 cents and if that party wins the largest percentage of the U.S. popular vote, they get US$1 back. On the other hand, if a bettor thinks the Republicans (Donald Trump’s party) will win the largest percentage of the popular vote, they can buy a Republican share for 25 cents and get US$1 back if the Republican candidate wins.
What this means is that, based on the wisdom of crowds, the odds are in the U.S. Democratic Party’s favour (so, Hillary Clinton will become U.S. president). It has a wide and growing lead in this “winner-take-all” market, with a “vote” for Clinton costing just under US$0.80, and a “vote” for Trump around US$0.20.
Many other political betting markets have become popular in recent years, including Betfair, PredictIt, and PaddyPower.
But the prediction markets are not infallible. A case in point was the recent Brexit vote. On election day, betting markets priced about an 85 percent likelihood that Britain would stay in the EU, while traditional polling indicated the vote would be close. As we now know, Britain voted to leave the EU by a narrow margin.
How did the wisdom of crowds get it so wrong?
It’s possible the Brexit prediction market was impacted by a few big bets by optimistic “remain” voters. But while political-betting markets may be small enough to be distorted by outsized bets, currency markets are not. And those markets reacted violently to the Brexit vote – they were as surprised as the betting markets.
The explanation probably lies in the cognitive biases that cause investors to make emotional, illogical decisions. It seems that the wisdom of the crowds works best when bettors are not unduly influenced by other bettors. Bubbles and crashes take place when bettors worry more about the other participants than about the real-world valuation of a market.
Brexit prediction market bettors may have fallen victim to “availability bias.” This is the tendency of investors to pay too much attention to new or easily remembered information when making investment decisions. Many expected the EU vote to resemble the 2014 Scottish independence referendum (where the status quo won handily even though the polls showed a tight race) – simply because that was the most recent precedent.
And keep in mind that prediction markets are a reflection of the probability of an event happening at some point in time, whereby election polls reflect a voter’s intention on the day the poll is taken. Unlikely things do happen.
Still, most of the time, the wisdom of crowds is superior to experts. No one, it seems, knows more than everyone.
Don’t fight the crowds when investing
What does this mean for the average investor? As we’ve mentioned before, the majority of investors will be successful if they just own a market index (using an ETF or an index fund). The market represents the collective wisdom of the “crowd” – millions of investors around the world. And it is very difficult to beat the market over time.
Yes, money can be made being a contrarian and going against what everybody else is doing. But staying invested in the market will probably earn you more in the long run.