The Wisdom of Crowds and the Fallibility of Markets

By Larissa Fernand |  19-09-19 | 
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DANIEL NEEDHAM, president and chief investment officer of Morningstar Investment Management, has been challenging investors across the globe in a stimulating exposition of ideas under the umbrella The Wisdom of Crowds and the Fallibility of Markets.

Thanks to his kinetic delivery that delved into a deep repository of knowledge, he had the audience listen with rapt attention at the Morningstar Investment Conference in Mumbai on September 18.

The terms are not new. But what was absolutely engaging was the way Daniel built up on it by laterally presenting seemingly non-related issues.

From the gestation period of the African elephant and the collective intelligence of bees, to music downloads and social influence on decisions; from the Diversity Prediction Theorem and Jack Treynor's Jelly Bean Experiment to the Efficient Market Hypothesis, his narrative was packaged with reason.

I have attempted (successfully, I hope) to put down a gist.

The Wisdom of Crowds

One of the most cited examples involves a group’s collective ability to accurately guess the number of jelly beans in a jar, where individuals in the group make guesses which are aggregated and averaged.

When finance professor Jack Treynor ran the experiment in his class with a jar that held 850 beans, the group estimate was 871. Only one of the 56 people in the class made a better guess.

Michael Mauboussin’s 2007 jelly bean results echoed the same conclusion. The average guess of the class was 1,151 while the actual number of beans was 1,116, a 3.1% error. Of the 73 estimates, only two were better than the average.


  • The group’s guess will not be better than that of every single person in the group each time.
  • There is no evidence that certain people consistently outperform the group.
  • In other words, if you run a dozen different jelly-bean-counting experiments, it’s likely that each time one or two students will outperform the group. But they will not be the same students each time. The group’s performance will almost certainly be the best possible.

Where does the accuracy of market prices come from, if not from a few determined investors who know they are right? It comes from the faulty opinions of a large number ​of investors who err independently.

- Jack Treynor​ (Market Efficiency and the Bean Jar Experiment in Financial Analysts Journal May/June 1987​)

​In The Wisdom of Crowds, James Surowiecki examined the proposition that, under the right circumstances, groups of people can be remarkably intelligent and often smarter than the smartest individuals in them. The crowd can reach a wise decision by leveraging on the collective intelligence of a group of people as opposed to depending heavily on the individual brilliance of one or a few.

(Not to be confused with Douglas Murray’s The Madness of Crowds which is dominating the current discourse).

In the world of biology, it’s called “swarm intelligence” when species rely heavily on collaborative decision making. Austrian behavioural biologist Karl von Frisch found that worker honey bees use a “waggle dance” and a “circle dance” to work together to make better decisions. The type of dance communicates the relevant information to the rest. Think of it as an online rating system for restaurants.

When a swarm of bees wants to set up a new colony it must come to a collective decision about where to build it. They will set off in groups in different directions to look for potential locations. When they return, they perform the waggle dance to communicate information about what they have found to the swarm. Different scouts attempt to pull the swarm towards or away from their preferred direction.

Eventually the colony decides as a group which scout to follow, making a decision no individual bee could ever have made on their own.

Behavioural Finance has taken the axe to Efficient Market Theory

Daniel Needham

If markets were always fully efficient, prices would already reflect all relevant information and it wouldn’t be possible for any investor to outperform after adjusting for risk.

Behavioural finance theory challenges efficient market theory because it shows that not all investors are rational and real-world arbitrage is limited.

Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day…”

- Warren Buffett in his 1988 letter to Berkshire Hathaway shareholders

Summing it up

# When you aggregate the guesses of many people working independently, you can arrive at a relatively accurate average result. This is commonly known as the Wisdom of Crowds. The crowd can be remarkably accurate, even better than the above-average participants.

# A crowd with independence and interdependence leads to correct price discovery (imitation distorts it.) For Wisdom of Crowds to work, we need Diversity (cognitive and social) and Independence (without too much influence from others).

#  Scott Page's book, The Difference, talks about the diversity prediction theorem, where: Collective error = average individual error – prediction diversity. In markets, prediction diversity occurs when people derive information from different sources and invest with different decision rules and heuristics.

#  Wisdom of Crowds emerges from diverse participants. Diversity breakdowns lead to infrequent inefficiency. Collective wisdom breaks down when insufficient diversity causes individual errors to correlate. Identifying breakdowns is key to active investing​.

#  Observe patterns rather than the actions of individual agents; markets can be a lot more rational than the underlying investors.

#  Markets behave as complex adaptive systems—it’s hard to assign cause and effect from so many agents acting, learning, and evolving within the environment. Traffic flow is an example of a complex adaptive system. As a driver you respond to the traffic flow, and then you influence it, then respond to altered traffic flow. With simple rules and independent plans, traffic jams are an emergent phenomenon that lack a clear cause-and-effect explanation.

# There is NO correct answer. There is NO finish line. It's highly subjective. 

Frequent Efficiency, Infrequent Inefficiency, and What to Do

  • Well-functioning markets have diverse participants independent participants (value/growth, short-/long-term, institutional/retail, fundamental/technical)
  • A breakdown of diversity leads to fewer investor types (remaining investors follow similar strategies, more correlated)
  • Agents of negative feedback are critical for markets (value, contrarians, long-term, re-balancers, volatility sellers)
  • Contrarians benefit from standing apart from the crowd tend; they tend to be lonely – especially at extremes (Contrarians tend to be concentrated on the short and long side of market extremes)

The central principle of investment is to ​go contrary to the general opinion, on the grounds that if everyone is agreed about ​its merit, the investment is inevitably too ​dear and therefore unattractive.​

- John Maynard Keynes (Letter to Jasper Ridley, 1944)

Further online reading

2019: Twitter thread on Daniel Needham's presentation: The Wisdom of Crowds and the Fallibility of Markets

2018: Daniel Needham: Finding Opportunities in an Uncertain Investing World

2016: George Soros: Fallibility, Reflexivity, and the Importance of Adapting

2014: Paul Woolley: The Fallibility of the Efficient Market Theory

2007: Michael Mauboussin: Explaining the wisdom of crowds


The Difference: How the Power of Diversity Creates Better Groups, Firms, Schools, and Societies by Scott Page

The Wisdom of Crowds by James Surowiecki 

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