Collective Brain

The Wisdom of the Crowds: What Do You Know that Millions Don't?

Collective Brain

Imagine you’re at a village fête, and you decide to have a go at guessing the number of jelly beans in a jar. How confident would you be of guessing exactly right or, say within one or two of the actual number? Chances are, it’s a bit of a long shot.

From my limited experience of these sorts of guessing games, the spread of guesses is huge; some come in way under and some way over, and it’s actually very unlikely that anyone’s guesses the precise number correctly.

But, if you add up all the guesses and then divide the total by the number of people taking part, it’s amazing how close the resulting number is to the actual number of jelly beans.

This is a brilliant analogy for the financial markets. We should view the markets rather like a giant super-computer. Every time we buy or sell a stock we express a view as to what a particular security is worth. Some will think a stock is underpriced and buy, and others will think it’s overpriced and sell. Individually, our opinions may be way off mark, but who can possibly argue with the collective wisdom of millions of people, including all the experts?

Does that mean, then, that all prices, at all times, are 100% “correct” — a perfect reflection of a stock’s actual value? No, it doesn’t. But prices do reflect all known information, and all new information is absorbed into prices in seconds (indeed, today, in fractions of seconds).

Stock prices can, and do, rise and fall very quickly in response to new information. Add human emotions like fear and greed into the mix, and prices can fluctuate wildly. But that doesn’t detract from the fact that the current price is by far the most reliable indicator as to what a particular stock is worth at any moment in time.

Do you really know something about a specific company which will have a significant impact on its future earnings that millions of others don’t? Do you honestly think you have a better grasp of where the economy’s heading than anyone else? If you do, you possess something truly valuable; but, with respect, the overwhelming likelihood is that you don’t.

There is a name that statisticians give to this phenomenon — the wisdom of crowds. In short it means that when it comes to problem solving, decision making or predicting, people are collectively smarter than individual experts. Sensible investors harness the wisdom of crowds by buying and holding index funds, and all investors would do well to remember it every time they are tempted to trade, or to put their trust in a professional “expert” to trade on their behalf. 

The wisdom of crowds phenomenon was first observed in 1907 by the British statistician Francis Galton at a competition at a country fair to guess the weight of an ox. In this, the second in a series of three videos about Galton’s work, I tell the story and, with the help of Mark Hebner from Index Fund Advisors, explain the significance of the wisdom of crowds for investors today.

 

 

For Part One of the series, click here.

For Part Three of the series, click here.