What Is Wisdom of Crowds?

What Is Wisdom of Crowds?

Let me explain what wisdom of crowds really means. It's the concept that big groups of people can be collectively smarter than any single expert when it comes to solving problems, making decisions, innovating, or predicting outcomes. You see, one person's view is often biased, but when you average out the knowledge from a whole crowd, those biases and noise get canceled out, leaving you with a clearer, more accurate result.

I often see this theory applied to financial markets to show why they sometimes run efficiently and other times, not so much. For markets to work well, the participants in that crowd need to be diverse and motivated by real incentives.

Understanding Wisdom of Crowds

James Surowiecki brought this idea to the forefront in his 2004 book, The Wisdom of Crowds, where he looks at how large groups have made better decisions in areas like pop culture, psychology, biology, and behavioral economics.

You can trace the roots back to Aristotle in his work Politics, where he talked about collective judgment using a potluck dinner as an example. He pointed out that a group can put together a better feast than one person alone.

But crowds aren't always smart. Sometimes they're the exact opposite. Think about the frenzied investors in the 1990s dotcom bubble. That crowd speculated on internet startups becoming profitable someday, driving stock prices sky-high even without revenue. When panic hit after sell-offs in major tech stocks, many companies crashed.

Characteristics of a Wise Crowd

According to Surowiecki, a wise crowd has key traits. First, there should be a diversity of opinions. Second, each person's view needs to stay independent, not swayed by others. Third, everyone in the crowd should form their opinion based on their own knowledge. Finally, the group must be able to combine those individual opinions into one collective decision.

A 2018 study built on this by saying that smaller crowds within a larger group can be wiser than the whole group. They had people answer questions privately as individuals, then in small groups where they discussed before agreeing on an answer. Those small group responses turned out more accurate than the individual ones.

Wisdom of Crowds in Financial Markets

This theory helps explain why financial markets, which are basically crowds, can be efficient sometimes and inefficient others. If participants aren't diverse or lack incentives, the market gets inefficient, and prices don't match real value.

In a 2015 Bloomberg piece, Barry Ritholtz argued that prediction markets, like futures, lack wisdom of crowds because they don't have a large, diverse pool. He noted failures in predicting things like the Greek referendum or the 2004 Iowa primary, where people just guessed based on polls without real knowledge.

Sure, the many can be smarter than the few, but not when crowd members influence each other. Consensus from people with poor judgment leads to bad decisions, like in the 2008 financial crisis. It also explains why democracies elect unqualified leaders sometimes. As Philip Ball wrote in 2014 for the BBC, it all depends on who's in the crowd.

Advantages and Disadvantages of Wisdom of Crowds

One big advantage is the diversity and broad thinking it brings. This gives you more perspectives and experiences for problem-solving than a single biased person. It also integrates information, pooling vast knowledge from many individuals into something bigger.

But there's criticism too. Humans often conform, leading to groupthink, which kills the diversity needed. Plus, when lots of people try to reach a consensus, it can spark disagreements and fights.

Examples of Wisdom of Crowds

Here are a couple of examples to show how it works. If you average the guesses from a large group about an object's weight, that average might beat the estimates from experts who know the object well.

Another one: The collective judgment of a diverse group can offset biases in a small group. Say you're guessing a World Series winner—fans might bias toward their team, but a big group with non-fans and those who dislike both teams could predict more accurately.

What Is the Difference Between Wisdom of Crowds and Crowdsourcing?

Wisdom of crowds assumes large crowds are smarter than experts for decisions, problem-solving, and innovation. Crowdsourcing, on the other hand, is about gathering info, work, or opinions from a big group, either voluntarily or from paid freelancers.

What Is the Crowd Within?

The crowd within idea says that averaging two estimates from one person is more accurate than a single estimate from them. It shows you can get wisdom of crowds effects even from an individual's multiple guesses.

What Are Wisdom of Crowds Criticisms?

A key criticism is that if the crowd isn't educated or diverse, the outcome won't beat an expert's and might be worse. The theory relies heavily on crowd quality. Also, people's tendency to conform leads to groupthink, undermining diversity.

The Bottom Line

In the end, wisdom of crowds theory holds that a crowd's knowledge leads to better decisions, innovation, and problem-solving than one person's. For it to work, the crowd must be large, diverse, and free from influence. This explains a lot about financial market efficiencies and inefficiencies.