There is wisdom in crowds, but more often wisdom in the wise. And you can beat the market, but not as often as the crowd would have you believe.
The America of the 1990s was fortunate in having not just one but two oracles. The course of events could be divined from the convoluted utterances of the inscrutable Alan Greenspan, chairman of the Federal Reserve. But it could also be observed in the daily fluctuations of the Dow Jones index. Since both indicators tended to say much the same thing – that all was for the best in the best of all possible worlds – the country was lucky indeed.
As stock prices have fallen, so has faith in both these oracles. But the idea that markets reflect the collective wisdom of millions of American investors and are an even more reliable measure of the democratic pulse than opinion polls remains influential.
These propositions have recently won endorsement from an unexpected source. James Surowiecki, the normally sceptical business columnist of The New Yorker, has, with his book The Wisdom of Crowds, won Wall Street plaudits – and my recommendation as a business book for the beach. Mr Surowiecki begins his wide-ranging argument with a striking example used by Francis Galton, the statistician. When the patrons of a country fair were asked to guess the weight of an ox, the average of their guesses was better than any individual one, and very close to the actual weight.
A tribute to the wisdom of crowds. Yet when I flew back to London a few days ago, I encountered general agreement that we should leave the navigation to the pilot, and not use the collective wisdom of the 150 passengers aboard to steer the aircraft.
When is there wisdom in crowds, and when should you visit the expert? If you want to be a millionaire, as a popular television quiz show offers, when should you ask the audience for the answer, as the show’s rules allow, and when is it better to phone a friend?
Galton’s result is well understood by statisticians. We are all moderately competent at guessing the weight of an ox: our estimates are unbiased, but subject to quite large errors. The more such estimates you average, the smaller the likely error – the mean of 100 estimates will have only one tenth the likely error of a single one. But if the error in my estimate is likely to be significantly greater than the error in yours, then incorporating my guess makes things worse, not better.
So the crowd is more likely to be right about things that do not matter, like guessing the weight of an ox or the number of jelly beans in a jar, and the expert is more likely to be right about things that do matter, like flying an aircraft or brain surgery. Where good judgments are important to us, we select people who are likely to be good at making these judgments and train them until they are very good at making these judgments. There are flight academies and medical schools, but no university offers a course on how to guess the weight of an ox or count the number of jelly beans in a jar.
That leads to a simple practical rule, which corresponds to instinct and practice. Address important issues to the most expert people you know, and go on asking until the average of their opinions does not change much. That is why there are two pilots on the aircraft, and why it is wise to take a second medical opinion, and a third if the two initial diagnoses disagree. But it is also why you are better advised to take good medical advice than to ask your friends what they make of your brain scans.
This approach will let you down if the supposed expertise is spurious, if different estimates are not really made independently, or if the guesses that are made are not unbiased; errors are more likely to be in one direction than another. And all three of these problems are endemic in modern business and finance: look at the fads and fashions among business gurus, the clustering of economic forecasters, and the predominance of buy recommendations among equity analysts. That is why it is a mistake to place too much confidence in either great men or the market.
You can, and should, attempt to compensate for these problems. Be sceptical: ask why you should buy what others want to sell. Discount the conventional wisdom. Be wise to conflicts of interest. There is wisdom in crowds, but more often wisdom in the wise. And you can beat the market, but not as often as the crowd would have you believe.