It has been a long time since I last wrote a book review. In fact, the last one I can remember was in Mr. Meyerhoff's English class during my junior year in high school. However, I was so taken by James Surowieki's book, The Wisdom of Crowds (Random House, 2004) that I wanted to share it with you.
The premise of The Wisdom of Crowds is that large groups of people can be surprisingly good at making decisions. In fact, when certain conditions are met, the collective judgment of the crowd is consistently and significantly better than the best "expert" in the crowd. In support of his premise, Surowieki's writing takes us from a livestock judging contest at an English country fair to space shuttle missions and almost every conceivable stop in between.
I know the idea of an "intelligent" crowd sounds counter intuitive to most of us. We like the idea that experts have the answers and we are generally skeptical (and rightly so!) of uninformed opinions. Most of us seem to believe what the Tommy Lee Jones character in Men in Black stated so eloquently: "A person is smart; people are dumb." But Surowiecki's book makes a convincing case that given the right conditions, groups of people have important things to say.
The key phrase, of course, is "given the right conditions." According to Surowiecki, groups are wisest when their members are independent, diverse, and decentralized. Group members are independent when their input is based on their own thinking and judgment; they are diverse when they possess different knowledge and skill sets; they are decentralized when members can act without having to conform to a controlling hierarchical bureaucracy.
I was particularly interested in what the author had to say about markets. To the extent the three preconditions are met, financial markets do a pretty good job at assigning value to a particular security and rationing risk among investors. Market prices may not always be "right"--after all, we never know if a stock price is correct until many years down the road--but the markets are very good at giving us a "best estimate" based on all that is currently known about a stock.
However, sometimes the necessary preconditions fail and the markets fail. For example, markets can suffer from what Surowiecki calls an "information cascade" which is another term for the bandwagon effect. This happens when investors pile onto a stock because everybody else is piling on. Their actions cause the stock price to rise which in turn pulls others onto the bandwagon. In this circumstance, members of the group are no longer independent and the judgments they render about the value of the stock have less to do with the stock itself and more to do with what they think others think about the stock. This dynamic causes the price to expand until someone or something causes the sentiment to shift and the bubble pops.
According to Surowiecki, the financial media plays an important role in this process. Citing a study conducted by economists Jeffrey Busse and T. Clifton Green on how the market reacted when CNBC ran a positive report on a particular stock, Surowiecki writes:
Busse and Green showed that prices reacted almost instantly to the news, moving higher in the 15 seconds after the segment appeared. More strikingly, the number of stock trades sextupled in the first minute after the segment. The speed of the reaction testifies, on the one hand, to the market's efficiency at incorporating new information. But what the study also shows is that investors were not reacting to the content of the report. Fifteen seconds is hardly enough time to decide whether what CNBC is saying makes sense or not.
Surowiecki discusses other evidence on the impact of financial "news" on market behavior including an experiment in the late 1980's by psychologist Paul Andreassen at MIT. In Andreassen's experiment, students were divided into two groups. Each group selected a portfolio of stocks and knew enough about each stock to come up with an estimate of that stock's fair value. The groups were then allowed to buy and sell their stocks over a period of time. The first group was allowed to only see the changes in the price of their stocks. The second group was allowed a steady stream of financial news that supposedly explained what was going on. Surprisingly, the less well-informed group did far better than the group that was given all the news.
As Surowiecki explains:
The reason suggested by Andreassen was that news reports tend to overplay the importance of any particular piece of information. When a stock fell, for instance, its fall was typically portrayed as a sign that further trouble lay in wait, while a stock that was on the rise seemed to promise nothing but blue skies ahead. As a result, students who had access to the news overreacted. They bought and sold far more frequently than the people who were just looking at the price, because they took each piece of information as excessively meaningful. The students who could look only at the stock's price had no choice but to concentrate on the fundamentals that they had used to pick their stocks to begin with.
According to Surowiecki, "CNBC magnified the dependent nature of the stock market because it bombarded investors with news about what other investors were thinking." In extreme situations like the late 1990 stock market or the real estate market earlier in this decade, these self-reinforcing information cycles caused a convergence in expectations and bubbles were born. Surowiecki concludes:
And the media does play a role that process. During boom times, it's rare to hear a discordant voice suggesting that disaster is nigh, while when things are going bad, it's hard to find someone who suggest that panic is a mistake. In this way, the media often exacerbates-though it doesn't cause-the feedback loop that gets going during a bubble. It's already hard enough for investors to be independent of each other. During a bubble, it become practically impossible. A market, in other words, becomes a mob.
Financial markets are only one small part of Surowiecki's very wide ranging discussion. In other segments the author looks at the disastrous breakdown in decision making that led to the Space Shuttle Columbia explosion, the attempts to moderate traffic problems in central London, the impact of Nielson ratings on television programming, politics and and on and on. It is a fascinating book, entertaining and compelling. I recommend it to anyone who is interested in gaining a better understanding about the world we live in and who is open to some interesting ideas on how to address some of the challenging problems we face.