The Wisdom of Crowds in Markets

Paper by Michael J. Mauboussin and Dan Callahan: “In 1932, Bernard Baruch, a wealthy financier who made his fortune on Wall Street in the early 20th century, contributed the foreword to a reprint of the 1852 edition of Charles Mackay’s classic book on markets, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. Invoking a dictum from Friedrich von Schiller, a German poet and philosopher, Baruch wrote: “Anyone taken as an individual, is tolerably sensible and reasonable—as a member of a crowd, heat once becomes a blockhead.” He added, “Without due recognition of crowd-thinking (which often seems crowdmadness) our theories of economics leave much to be desired.” About 40 years later, Eugene Fama, a professor of finance at the University of Chicago and a winner of the Nobel Prize in Economics, published “Efficient Capital Markets: A Review of Theory and Empirical Work.” It is among the most famous papers ever written in finance. This might be considered the theory Baruch had in mind. Fama posited, “A market in which prices always ‘fully reflect’ available information is called ‘efficient.’” Fama found that strategies investors commonly applied to try to outperform the market, including using past price patterns to project the future and doing fundamental analysis to distinguish between price and value, failed in their objective. In other words, there is no reliable way to take advantage of the blockheads. Nearly all those who study markets carefully agree that they appear sensible for the most part, as theory would have it, but periodically go bonkers. Having one framework to accommodate both realities is useful. James Surowiecki wrote about such an approach in 2004. Riffing on Mackay’s madness of crowds, Surowiecki called his book, The Wisdom of Crowds. He showed that crowds can be remarkably accurate in reflecting objective values or outcomes. Indeed, the prices generated by collectives commonly converge on the proper theoretical price in experimental settings…(More)”