Many value investors pride themselves on their ability to stand apart from the crowd; after all, often it is only by standing apart that one can forage for those morsels left carelessly behind by the aimless herd.
Wall Street Journal veteran Jonathan Clements made this point eloquently in a recent article:
“To invest successfully, we need to stand apart from the crowd, never purchasing something we don’t understand and never buying just because others are doing so. That doesn’t mean we should be knee-jerk contrarians. But it’s crucial to diversify broadly, while shunning big bets on the market’s most popular merchandise.”
The contrarians are certainly not wrong, at least not all of the time, yet it is also true that crowds can prove extremely useful tools in assessing all manner of problems, including investment theses. Investors ignore the situational utility of the crowd -- especially the knowledgeable crowd -- at their peril.
The miracle of aggregation
Sir Francis Galton, the renowned Victorian statistician and polymath, famously conducted an experiment in which he presented an ox to a crowd of hundreds of individuals, asking them to guess its weight. What he found was that the crowd as a whole was able to hone in on the true weight far better than could any single individual.
This might seem strange to value investors, who are so often primed to take the contrarian stance as default. Yet, as authors Philip Tetlock and Dan Gardner have explained, Galton’s observation makes perfect sense when one thinks about the composition of a crowd, and the additive quality of useful knowledge:
“Some reverently call it the miracle of aggregation but it is easy to demystify. The key is recognizing that useful information is often dispersed widely, with one person possessing a scrap, another holding a more important piece, a third having a few bits, and so on. When Galton watched people guessing the weight of the doomed ox, he was watching them translate whatever information they had into a number...Hundreds of people added valid information, creating a collective pool far greater than any one of them possessed. Of course they also contributed myths and mistakes, creating a pool of misleading clues as big as the pool of useful clues. But there was an important difference between the two pools. All the valid information pointed in one direction...but the errors had different sources and pointed in different directions. Some suggested the correct answer was higher, some lower. So they canceled each other out. With valid information piling up and errors nullifying themselves, the net result was an astonishingly accurate estimate.”
Clearly, the so-called “miracle of aggregation” is anything but miraculous. What Galton observed was merely an emergent property of asymmetric individual knowledge bases combining to produce a net improvement in group knowledge.
In other words, the crowd is smarter than the individual because intelligent and knowledgeable members help converge on the truth, while unknowledgeable members cancel each other out.
The emergence of wisdom
The power of the crowd rns deeper still, if we can choose its composition. Galton made use of a random set, which included individuals with additive knowledge, as well as many who were totally ignorant. Perhaps, by eliminating the non-additive individuals in favor of a more robustly knowledgeable crowd, we can yield superior results.
This hypothesis appears to be proven out in practice, as can be seen when we turn once again to Tetlock and Gardner. They offer a clean and concise explanation of why some crowds are better than others:
“How well aggregation works depends on what you are aggregating. Aggregating the judgments of many people who know nothing produces a lot of nothing. Aggregating the judgments of people who know a little is better, and if there are enough of them, it can produce impressive results, but aggregating the judgments of an equal number of people who know lots about lots of different things is most effective because the collective pool of information becomes much bigger.”
Fundamentally, a crowd is an aggregation of knowledge of its individual members. When a subset of the crowd does not know what it is doing, it usually cancels out, leaving only the useful, convergent information. However, the quality and precision of a group’s judgments can be amplified both by increasing the number and quality of knowledgeable members, and removing unhelpful individuals who -- even if their contributions ultimately net to zero -- are not adding value to the aggregate (or collective) decision-making process.
Verdict
The idea that crowds can both be mad and wise may seem counterintuitive, but the evidence speaks for itself.
Looking to the crowd to guide one’s every decision is obviously folly, but it is equally foolish to ignore the benefits that can be had by activating -- and tapping into -- an engaged and knowledgeable crowd.
Investors would be wise to think again before shunning the crowd out of hand.
Disclosure: No positions.
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