The Collective Wisdom

This article is very much in line with the last one, ‘The Silent killer’. The purpose of ‘From 0 to 1 in the Stock Market’ is to not only learn the actual fundamental principles of the stock market, but to expand one’s horizon of knowledge to grasp a better edge against other investors.

By reading different sources of information, I got to realize there’s another concept that’s very intricated in the stock market, but that’s hidden in plain sight. The collective wisdom or wisdom of the crowds, as I see it, refers to a weighted average of society’s, or in this case, investors’, thoughts/minds/ideas.

The Pricing System

In his essay “The Use of Knowledge in Society”, Friedrich Hayek theorizes on how societies collude to define the price of things. Information is scattered all across the world; each person has his/her own thoughts, ideas, necessities, background, and all their singular characteristics as well as context. When people decide to buy or sell something, they are implicitly utilizing all these available resources and information to make the decision with its individual highest expected value. After a group of people or so called, societies, send enough of these ‘signals’, prices are set. Therefore, we can safely think of prices as an average of societies knowledge.

The concept can be taken to the extreme. When done so, different theories arise, like the following.

The Efficient Market Hypothesis

I’m pretty sure you are most likely familiar with this hypothesis, but nonetheless, a brief introduction. The efficient market hypothesis states that asset prices reflect all available information. What this fundamentally means is that each investor, when deciding to buy or sell a stock, is determining what the price of such stock should be according to his/her circumstance. Ultimately, all stock prices are theoretically perfectly settled since they have baked in them all the financial community’s ‘knowledge’, getting to the last part of the hypothesis. “A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.”

This theory has been widely covered and debated. Across the past century, the empirical evidence suggest that it is incorrect. Either by the acknowledgement of how the market behaves, in a pronounced pendulum, or by the mere existence of investors that have consistently beaten the market for long periods of time.

However, by the sole fact of the hypothesis being proven incorrect, the vast majority of the financial community discarded the underlying concept within it. It is of my view that a very valuable insight relies in the middle of both theories.

The Wisdom of Crowds

The subtitle refers to a comprehensive study of how a collective of people can solve problems better than most individuals, if under the condition of being diverse, aggregated and incentivized. It’s also been covered in different books, papers, articles and podcasts. The information I’ll utilize here is from a research article published by Michael Mauboussin, from Legg Mason Capital Management, in 2007. In it, some examples are shown to illustrate how it works (I’ll use the first one):

Problem: Who wants to be a millionaire?

In his TV show, Jim Surowiecki called people to the stage to answer a series of multiple choice questions with a million dollars payoff if they got all right. He gave contestants three options to help them in the task:

a)      Eliminate two of the four answer choices.

b)     Call an expert for counsel.

c)      Poll the studio audience.

The first option leaves the probabilities as a simple coinflip and the expert used to be right two out of three times on average. Surprisingly, the audience was right on 90% occasions. There’s a statistical explanation Scott Page gives on his book ‘The Difference’ of how can this be possible.

Imagine a random crowd is asked which person from the following list was not a member of ‘The Monkees’. (The answer is c) Roger Noll))

a)      Peter Tork

b)     Davy Jones

c)      Roger Noll

d)     Michael Nesmith

Now imagine a crowd of 100 people with knowledge distributed as follows:

• 7 know all 3 Monkees

• 10 know 2/3 Monkees

• 15 know 1/3

• 68 have no clue

The assumption here is that while a person has less information, more random will his/her answer be, assigning equal probabilities to each potential answer. So, here’s how the crowd would respond:

• The 7 who knew them all vote for Noll

• 5 of the 10 who knew 2/3 will vote for Noll

• 5/15 of the 15 who knew only 1 Monkee will vote for Noll

• 17 of the 68 (one fourth) of the clueless will vote for Noll

The result? Roger Noll will get 34 votes, versus 22 votes for each other choice. The crowd picks the winner, purely out of statistics.

How is this Useful?

Realizing how crowds work puts you into perspective into how much chances they have of being right. It should make one really respect the ‘collective wisdom’ before tearing it apart, considering it useless. When respect is in place, the correct questions could be asked to avoid falling for traps in the market, the easiest to think of:

• Why is the market pricing this so low? There could be a reason acknowledged by the collective wisdom, so beware.

Personal Commentary

As firstly stated, it is known that market behavior is driven from panic to euphoria and in both states, it tends to be incorrect. However, when respect is in place, it allows us to not fall for potential mistakes. Since it tends to be mostly correct, we have to at least give a thought to why could the market be pricing something at such price. Sometimes the collective wisdom gives signals and on most occasions, it is a good practice to pay attention.

I hope you enjoyed the article, I personally find this kind of stuff absolutely revealing.