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Are the Crowds Wise or are they Mindless?

This question may have occur to you that are groups or crowds better and wiser than individuals? Or are they somewhere on the craziness scale?

The question arises because you hear of both the wisdom, as well as the madness of crowds.

After all, both these books are considered classics, especially for those interested in investing: Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay and The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations by James Surowiecki
Where does the truth lie?
It is actually a simple answer to this.
Here's the key insight: Averaging INDEPENDENT estimates improves estimates or forecast accuracy.

If, for instance, hundreds of people estimate, essentially guess, the number of marbles in a jar, the average is often remarkably close to the actual number, even if the individual estimates are way off.

Similar results hold when you are trying to estimate or predict more nuanced stuff like company profits.

Why does this happen? Because aggregating independent responses reduces noise or random variation.

But this holds if and only if the estimates are made independently.

Contrary to our general impression, exchanging ideas and discussions reduces accuracy as people get influenced by one another.

Juries, corporate discussions etc get derailed by group dymanics.

As Cass R. Sunstein, Daniel Kahneman, and Olivier Sibony write in the book 'Noise: A Flaw in Human Judgment', "Groups can go in all sorts of directions, depending in part on factors that should be irrelevant. Who speaks first, who speaks last, who speaks with confidence, who is wearing black, who is seated next to whom, who smiles or frowns or gestures at the right moment, all these factors and many more affect outcomes."

The net result is that many similar corporate groups faced with the same facts and data can come up with very different decisions in all sorts of matters from recruitment, retrenchment, expansion, communication, environmental policy, product launches and more

There is also the human need to belong to the group and not rock the boat. Later in the discussion, this prevents participants with a contrary view, from speaking out. Also persons with no clear view either way are likely to go along with the initial or important speakers.

Basically, as the book further says, "aggregating the judgements of multiple individuals reduces noise, but because of group dynamics groups can add noise too."

Deciding on a corporate initiative or on compensation in case of a jury?

You're likely to end up with a deadly combination of extreme results & misplaced confidence!

You will find almost everyone agreeing vehemently with and supporting the course of action decided.

At times the groups may come up with the right or wise decision but similar groups can also follow tyrants or cult leaders under the sway of a shared illusion.

Groups that appear very alike in composition, can come up with very different decisions on the same matter, depending on the dynamics among group members.

Now you may ask, what does all of this have to do with investing?

In the markets, do you spend a lot of time tracking what your friends are doing, what 'experts' or institutions are saying and doing? Are you a member of WhatsApp chat groups or those on certain websites where investors and traders share ideas, tips, analysis?

First is the fact that you may not get an actual or clear picture of what entities are really doing for example for an institution you might know only part of their portfolio or strategy.

But there is another important point: This sharing and exchanging of ideas and tips contaminates your thinking. More often than not, over the course of a discussion, more and more people buy into the dominant thought or idea.

After a while it appears that there is only one logical course of action as far as that stock or trade is concerned.

This is the risky part. Without your being consciously aware of it your mind has been hijacked by group dynamics. Paradoxically you will likely have more confidence in this decision reached after discussions than in your initial hypothesis whether this decision is the same or diametrically opposite.

It is not just a waste of time, it is actually likely to lead you off track and you will end up worse off in terms of decisionmaking.

Therefore very important to maintain the sanctity and independence of your analysis and not get into an exchange of ideas which counter intuitively will result in a declining quality of decisions.

This is an important point to ponder over because it goes against our general tendency and thinking.

Even a number of fund managers spend time talking to brokers and others market participants about what everyone else is thinking or doing in the markets.

Back when I used to be active on the Sell-side (ie as a stockbroker), I remember a Mutual Fund Investment team proudly say that they had a day a week to do their own work & not talk to brokers.

My question (not articulated, as this was a client): Why only ONE day?

Talking to brokers or anyone about what everyone else is doing is a waste of time at best and as we saw above, can actively mislead you.

 Holds true, whether you are investing for yourself or for others.

While pooling independent opinions improves the quality of decisions, 'talking' reduces it.

Even opinions of various analysts across brokerage houses may not be truly independent at all, as most analysts like to sit in the consensus, if for no other reason that it is the safest strategy to keep their job.

This is besides the fact that most brokerage analysts will not say anything negative about a stock held by one of their major clients and in any case, hardly only a very small percentage of their ratings will ever be 'Sell'.

At best you can look at brokerage research reports to collect facts about a company but do not give weightage to the opinions expressed. The issue is that, consciously or not, you may anyway be influenced by the opinions

I, for one, minimize not just market gossip but even internal meetings unless there is a proper agenda. Daniel Kahneman's studies have only proven that this is the right strategy.

Only one way to invest well: Do the work!

Or outsource it

For a more nuanced understanding of this (and much else), read 'Noise' by Kahneman, Sibony & Sunstein.
From the desk of 

Devina Mehra

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