In his 2004 book The Wisdom of Crowds, James Surowiecki posed a rather radical point of view: that the madness of crowds is overrated, and that oftentimes, the crowd is actually surprisingly correct.
Surowiecki launches his book by mentioning an observation that British scientist Francis Galton had in 1906, at an ox-weighing contest. The group trying to guess the weight of an ox included not only people who worked with cattle every day, but also non-experts with little or no knowledge of cattle. Out of 787 guesses, the average guess was 1,197 pounds. The ox's actual weight was 1,198 pounds -- right on the money. Galton said, "The result seems more creditable to the trustworthiness of a democratic judgment than might have been expected."
The Wisdom of Crowds contains many interesting examples and discussions supporting the theory, and of course, the book is especially timely considering the fact that such sentiment has been evident on the Internet. Consider blogging, Wikipedia, Netflix's
One of my biggest questions upon picking up the book was, what about bubble mentality? Several well-known bubbles have expanded (and burst spectacularly) in recent years -- the dot-com bubble, the telecom bubble, and the real estate bubble. In these cases, huge numbers of people exhibited what proved later to be irrational behavior while following the crowd; in fact, the crowd was arguably the most important element of fostering the irrational ideas. Furthermore, any investor who has ever taken the negative side of a debate regarding the outlook for certain companies with large, loyal, let's say rabid, fan bases -- think Sirius
Surowiecki admitted that groupthink can occur. For collective intelligence to work, he contended you need a myriad of views and data. He said, "Diversity and independence are important, because the best collective decisions are the product of disagreement and contest, not consensus or compromise." He discussed such potentially dangerous developments as information cascades, where a few influential individuals might steer the crowd in what could very well be an irrational direction. Furthermore, experts and academics, as well as businesspeople in small groups, can be so alike in their outlooks that they become myopic, deciding (probably unconsciously) that dissent is not useful; dissenters might find it's easier to change their own opinions than duke it out with the group. Bubbles work in a similar way, when everyone buys into conventional wisdom; collective intelligence relies on the existence of people who aren't easily swayed by a crowd.
The Wisdom of Crowds is a good read for investors for obvious reasons. The stock market is obviously a crowd that gauges different types of information. While Surowiecki does bust on experts a little bit in his book, he reminded readers that he's not writing the book to say there's no place for experts -- for a group to display collective intelligence it's going to have a mix of experts and non-experts, geniuses and average Joes, alike.
While reading The Wisdom of Crowds I couldn't help but think of how it relates to the general spirit of Foolishness in investing. The Motley Fool has always been all for fostering community while thinking for (and educating) oneself, sometimes in exact opposition to so-called experts, as well as having healthy respect for dissenting points of view. After all, our Dueling Fools feature, where two Fools spar with one another over stocks, has been around since longtime Fool Rick Munarriz created it 10 years ago, and was revitalized last year.
Fast forward to 2006, and we've been developing and beta testing a new Foolish diversion called Motley Fool CAPS, which is now live and free for all to participate. It definitely speaks to the idea of community intelligence and how it can help make us all better investors.
Call it a research service, call it a tool (it is both of these things, and likely many more), CAPS allows investors to make mock portfolios through which they can try to beat the S&P, their peers, or even Wall Street's experts and talking heads. (Ever wanted to test your acumen against Cramer? Now's your chance to join our new beta service.) CAPS takes the temperature on what kind of sentiment a large group applies to certain stocks, giving stocks ratings that give a good idea of what the group's forecast is for those stocks' futures.
Even if crowds make you claustrophic, The Wisdom of Crowds is a fun, thought-provoking read that puts forth a theory that could have very important implications in business, investing, and the direction of the Internet these days.
Netflix is a Motley Fool Stock Advisor recommendation. XM Satellite Radio is a Rule Breakers pick. Wal-Mart is an Inside Value selection.