What is Wisdom of Crowds?
Wisdom of crowds is that the concept large groups of individuals are collectively smarter than individual experts when it involves problem-solving, deciding, innovating and predicting. The wisdom of crowd’s concept was popularized by James Surowiecki in his 2004 book, The Wisdom of Crowds, which shows how large groups have made superior decisions in popular culture, psychology, biology, behavioral economics, and other fields.
Wisdom of crowds refers to the thought that enormous groups of individuals are collectively smarter than individual experts. Within financial markets, the thought helps explain market movement and herd-like behavior among investors.
It was first popularized by New Yorker writer James Surowiecki in his 2004 book, The Wisdom of Crowds.
For crowds to be wise they need to be characterized by a diversity of opinion and every person’s opinion should be independent of these around him or her.
Understanding Wisdom of Crowds
The idea of the wisdom of crowds is often traced back to Aristotle’s theory of collective judgment as presented in his work Politics. He used a potluck dinner as an example, explaining that a gaggle of people may close to make a more satisfying feast for a gaggle as an entire than what one individual might provide.
What’s needed to make a Wise Crowd?
Crowds aren’t always wise. In fact, some are often the other. Take, as an example, frenzied investors who participate during a stock exchange bubble just like the one that occurred within the 1990s with dotcom companies. The group, or crowd, involved during this bubble invested supported speculation that internet startups would become profitable at some point within the future. Many of those companies’ stock prices soared, despite the very fact that that they had yet to get any revenue. Unfortunately, an honest portion of the businesses went under as panic ensued within the markets following mass sell orders on the stocks of a number of the main tech companies.
But, consistent with Surowiecki, wise crowds have several key characteristics. First off, the gang should be ready to have a diversity of opinions. Secondly, one person’s opinion should remain independent of these around them (and shouldn’t be influenced by anyone else). Next, anyone participating within the crowd should be ready to make their own opinion supported their individual knowledge. Finally, the gang should be ready to aggregate individual opinions into one collective decision.
A 2018 study updated the wisdom of crowd’s theory by suggesting that crowds within an existing group are wiser than the group itself. The researchers called their results an improvement over the prevailing wisdom of crowd’s theory. They recorded responses to their questions privately, from individuals, and collectively, by having small groups that were subdivisions of larger ones discuss an equivalent question before providing a solution. The researchers found that responses from the tiny groups, during which the question was discussed before a solution was prescribed, were more accurate as compared to individual responses.
Wisdom of Crowds in Financial Markets
The wisdom of crowds also can help explain what makes markets, which are a kind of crowd, efficient sometimes and inefficient at others. If market participants aren’t diverse and if they lack incentives, then markets are going to be inefficient and an item’s price are going to be out of step with its value.
In a 2015 Bloomberg View article, wealth manager and columnist Barry Ritholtz argued that prediction and futures markets, unlike markets for goods and services, lack the wisdom of crowds because they are doing not have an outsized or diverse pool of participants. He points out that prediction markets failed spectacularly in trying to guess the outcomes of events like the Greek referendum, the Jackson trial, and therefore the 2004 Iowa primary. The individuals trying to predict the outcomes of those events were simply guessing supported public polling data and didn’t have any special individual or collective knowledge.
While there’s merit to the thought that the various are smarter than the few, it’s not always true, particularly when members of the gang are conscious of and are influenced by each other’s ideas. Consensus thinking among a gaggle of individuals with poor judgment can, unsurprisingly, cause poor group decision making; this factor may are one among the causes of the 2008 financial crisis. It also can explain why democracies sometimes elect unqualified leaders. In other words, as explained by British science writer Philip Ball during a 2014 article for the BBC, it matters who is within the crowd.
Examples of Wisdom of Crowds
Two examples that show how the concept works:
By averaging together the individual guesses of an outsized group about the load of an object, the solution could also be more accurate than the guesses of experts most conversant in that object.
The collective judgment of a various group can catch up on the bias of alittle group. In trying to guess the result of a World Series game, fans could also be irrationally biased toward their preferred teams, but an outsized group that has many non-fans and individuals who dislike both World Series teams could also be ready to more accurately predict the winner.