Which rule applies to investing: the wisdom of crowds or herd mentality?
According to James Surowiecki, author of The Wisdom of Crowds, all you need in order to make good decisions — good investing decisions being a subset of all good decisions — is a diverse, independent, decentralized, and aggregated crowd to follow. Let the mob mentality, or the most intelligent in that community, do the work and blindly follow. The theory of crowd wisdom will surely lift the value of your investments.
Even if this theory is correct, it’s difficult for everyday investors to follow in practice for a number of reasons.
1. Hype masks true information. Mass media will occasionally provide information about the most diverse, independent, decentralized, and aggregated slice of the crowd, but that information is usually uninteresting to the mass audience. In a culture where the transmission of information relies on the ability to sell advertising space, ratings rule over information. The media would much rather tell a story about celebrities forced into foreclosure than one about today’s safe real estate investments.
2. Personal bias. The most extreme form of this is the penny-stock spam email you probably receive just about every day. This scam is straightforward: the perpetrator buys cheap stock in some obscure company and sends out millions of email messages. The email messages informs people who may or may not know better that the stock is guaranteed to soar and instructs them to buy now. Even a one percent response rate is enough activity to buoy the stock for the perpetrators, whi will quickly dump their holdings, leaving the fallen stock price for the suckers who bought into the scheme.
On the more reasonable side, stock brokers have their own personal interests in mind and are driven by the promise of commissions and fees. Even some journalists with close ties to financial industry have much to gain by promoting investments or insurance policies that they might not otherwise to help their friends. Investment companies have highly-paid teams of marketers to help write advice-giving articles for corporate rather than fiduciary interests.
So whose information do you trust?
3. Delay of information. Warren Buffett is one of the greatest investors of all time, there’s no doubt about that. It’s tempting to simply follow Buffett’s moves and decisions — albeit on a smaller scale — because he clearly knows what he is doing. The problem that I’ve found is that the public doesn’t hear about the details of his investing transactions until long after they’ve occurred. If you’re following Buffett’s moves three to six months after he’s made his decisions, then you’re missing the benefits that he has been enjoying. In fact, if Buffett were to buy into an investment and sell out of that same investment within a small time frame, you may even be the sucker buying Buffett’s sold shares.
One person does not make a crowd, even if it is Warren Buffett. Consider the collection of all high-level corporate executives, large university endowments, and all their investment managers. Again, you won’t hear of their investing decisions until well after these decisions have been made. It’s almost impossible to benefit from the wisdom of this particular crowd unless you’re able to follow their investments in real time.
Rather than looking for wisdom by following the perceived crowd, it may pay off to move against the mob. The contrary viewpoint may not always be right, so this particular technique of decision-making comes with its own risks.
Image credit: tboothhk
Updated February 10, 2011 and originally published July 1, 2008.