Each Sunday, The Simple Dollar reviews a personal development or personal productivity book.
Christmas toy marketing, and
parental responses to Christmas toy marketing. A few astute readers made the observation that I was talking about “groupthink” in each of the posts. Those readers were correct. The reason why I was thinking so much about “groupthink” at that moment was that I was reading James Surowiecki’s The Wisdom of Crowds.
What’s it about, and why am I talking about this book here? The Wisdom of Crowds makes the case that large groups of people are smarter than an elite few, no mater how brilliant the few are. Crowds, according to Surowiecki, are better at solving problems, innovating, coming to wise decisions, and predicting the future.
Obviously, from a personal finance perspective, this is a baffling thing, and I went into this book deeply questioning the premise. I’ve seen countless examples of how foolish investors can be, building up investment bubbles almost every decade. In fact, Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds makes more or less the opposite point in the investing world – following the crowd will bankrupt you.
Surowiecki’s book attempts to explain group behavior in general, though, and actually has some explanations for faulty groupthink. In the end, I saw a lot of merit in his argument, enough so that I think this book is well worth reading and thinking about when trying to understand how others behave.
Navigating Through The Wisdom of Crowds
The first part of the book focuses on the theory behind the wisdom of crowds, looking at evidence of its existence and how it actually works.
1. The Wisdom of Crowds
The book opens with a handful of interesting anecdotes that show instances where a crowd makes better choices than an individual ever could. I thought I’d highlight two of these to show what Surowiecki is talking about.
Sports bookies When you place a bet on a sporting event in a Las Vegas casino, you’re usually talking about a line bet. In such a bet, the casino provides a “line,” which means that one team in a bet is favored to win by a certain number of points – say, the Giants are favored to beat the Dolphins by 6 1/2 points. With a line bet, you bet $11 (to potentially win $10) and take either the Giants or the Dolphins. If the Giants win by 7 or more points and you picked them, you win the bet – if they score less than that (even if they still win the game by, say, 5 points), you lose the bet. Casinos make money by having betting be more or less equal on each team – if $110,000 is bet on each team, the casino will bring in $220,000, then pay out $210,000 ($110,000 in bettor’s money and $100,000 in winnings), keeping $10,000 to themselves. What happens over time is that casinos adjust that line based on how the crowd is betting to try to get equal amounts on each side of the bet, thus the crowd effectively sets the line. Even more impressive, the final line ends up being incredibly accurate over time – early bets, before the crowd has pushed the line one way or another, tend to be more accurate (and thus more lucrative) than the final, crowd-adjusted line.
Challenger versus the stock market When the Challenger space shuttle exploded in early 1986, there was an immediate negative reaction on Wall Street to the four companies involved in constructing the shuttle: Rockwell International, Lockheed, Martin Marietta, and Morton Thiokol. The final company, Morton Thiokol, was the one responsible for building the solid-fuel booster rocket. By the end of the day, all of the companies except Morton Thiokol had rebounded, even though the cause of the accident had not been known. It took six months for the cause of the accident to be fully understood – and, sure enough, it was the rocket made by Thiokol that was at fault. The Wall Street crowd had fingered the culprit – and used their cash to show their confidence in it.
This whole chapter is anecdotal in nature, full of examples like the two above.
2. The Difference Difference Makes
We’ve all witnessed this phenomenon over and over again. When a new market springs up (let’s say, the Internet), a huge handful of companies jump on board, each with their own twist on a general theme. During the first dot-com bubble, the number of online retailers, all with variations on the idea of selling consumer goods to people, was immense. Eventually, though, the consumers move in and start selecting, eventually trimming down the market to those who are good at providing a service (Amazon.com, for instance) and weeding out those that are bad or provide a service that is too niche (Boo.com, anyone?).
Surowiecki uses the automobile market in this chapter as another example, showing that almost the same exact thing happened in that market. A bunch of companies started out trying all sorts of variations on the horseless carriage. The companies that survived were the ones that put quality vehicles out there at a price people could afford. This was usually due to the automobile design and how easy it was to assemble the cars in a factory – this is why Ford survived – or when a handful of fairly successful companies joined forces to share assets – this is how GM got started. In both cases, all of the moves by the companies were made to survive, and to survive you had to please the crowd or else they would just go elsewhere for their product.
3. Monkey See, Monkey Do
After spending two chapters hitting home with the idea that crowds are infinitely wise, Surowiecki addresses some reasons why crowds don’t always make the best choice. For the most part, the elements discussed here boil down to one thing: imperfect information.
For example, when a crowd chooses a restaurant, it’s quite often the result of people randomly trying restaurants, then the word beiing spread about the first good restaurant that people try. This is why marketing is valuable – it gets people to the door, again altering the information flow.
4. Putting the Pieces Together
Another example of information manipulation is the war in Iraq. The first intelligence that came out about weapons of mass destruction was wrong, and supplied incorrect information to the crowd, thus convincing the crowd that war was the right avenue. In the presence of more intelligence, a different picture became clear, thus the crowd largely turned against the war.
Surowiecki also looks at open source software versus closed source software. The reason that open source software has had a hard time finding market share versus closed source software is because of the information flow. People who make software decisions are often underinformed (or misinformed) about open source software
The conclusion? Crowds can be manipulated. One major requirement of a crowd being wise is that they have equal and thorough access to all of the information, and that’s often not true.
5. Shall We Dance?
In the absence of true information, crowds often invent their own information in various ways. For example, since there’s no information for deciding who gets a seat on the subway, seats are often filled on a first come, first served basis – it’s a subtle arrangement that almost everyone simply follows.
This actually gets rather complex. If you ask a group of New York law students where they would go to meet someone in the city if they forgot where they were going to meet, a majority suggested the information booth at Grand Central Station. A time? A vast majority said at the stroke of noon. Without any information at all, there’s at least a chance that these unwritten rules would guide two law students to the same place at the same time to meet for lunch.
Even more interesting, people often invent their own individual strategies for some events. Though those individual strategies aren’t all that good, the average of those strategies is killer. Surowiecki recounts an anecdote about a bar that is optimally fun when the bar is 60% full. On any given night, it is either more or less full, and different people use different strategies to determine where to go. However, over a year, the average crowd at the bar was at 60% capacity.
6. Society Does Exist
Another piece to this whole puzzle is the idea that members of society are expected to play fair, by certain unwritten rules, and when people don’t play fair (in the context of these rules), the crowd turns against them, even if their move is completely reasonable and justified.
Take the umpire at a baseball game. It’s expected that an umpire will make largely good calls, with occasional bad ones mixed in fairly randomly. However, if the umpire makes a rare bad call – something that’s part of the expected behavior – against the home team, the crowd, which was previously supportive of the umpire, will turn against him with a vengeance.
Simlarly, look at Richard Grasso, the former CEO of the New York Stock Exchange. Even though he did an excellent job as head of the NYSE, eventually his salary became “too high” and violated a subtle “rule.” What happened? The crowd turned against him and demanded his ouster. He did an excellent job as CEO, but was forced out of his job because he was paid too much for his work – he didn’t play “fair” by the “rules.”
The second half of the book looks at how the idea of crowd wisdom causes problems – and can be used to solve various problems.
We’ve all been caught in traffic jams before – these happen because the crowd has determined that this is the best path to follow. They’re frustrating not only for us, but for road planners as well, and thus there are several potential solutions out there to the problem.
The Vickrey solution basically involves putting a toll on the most heavily trafficked roads. When a road is regularly filled to capacity and triggers traffic jams, that road should be a toll road. Why? Without a toll, some aspect of that road has caused it to have extra value beyond that of other, similar roads. Charging a toll will force some of the crowd off of the road, causing them to seek another path, thus making that road more useable for people willing to pay the toll.
This technique is being implemented (or has been implemented) all over the place, from Singapore to London, and the same logic exists in many other forms. It is that logic, for instance, that has convinced people to suggest to me that I begin charging a “toll” for The Simple Dollar (something I’m not going to do, by the way).
Surowiecki here looks at the evidence that science is largely defined by hierarchy, not by ideas. A graduate student might come to a brilliant conclusion, but often it is his PI that gets the credit, for example. Similarly, ideas are often ridiculed until enough “name” scientists are convinced, then the crowd follows them.
What does this mean for science? It means that, in each field, there are a handful of people that are the ones who determine what is acceptable scientific thought and what are not, and that the crowd follows these people, not the ideas.
Part of the reason for that is tradition, and thankfully in many sciences that tradition is changing. In mathematics and physics, for example, arXiv has somewhat democratized the presentation of new ideas.
9. Committees, Juries, and Teams
There is a lot of evidence that small groups tend to come to some atrocious conclusions. Take the jury for the Simpson trial – the larger crowd that followed the whole trial on television was largely convinced of his guilt, but the jury rather quickly determined that Simpson was not guilty.
Surowiecki argues here that small groups also come to the correct conclusion, but that smaller groups are much more susceptible to incomplete information. For example, a jury is often selected based on their pre-existing dispositions, then fed alternating narratives by the prosecution and the defense, each full of incomplete information. In the case of the Simpson trial, the external world had much more information than the jury had to come to its conclusions.
This rule of thumb basically holds for any small group. You and your small group of friends might all agree that Restaurant A is the best one, but that’s because none of you have tried Restaurant B or Restaurant C, for example.
10. The Company
Companies are the perfect example of the wisdom of crowds. Companies that succeed are the ones that prove best at serving a particular crowd. That crowd might be large or small or might consist of customers or of stockholders, but successful companies are the ones that serve their crowds well.
One might immediately think, “What about Enron? Who did they serve?” and the answer is obvious: their upper management, and no one else. What Enron reveals is that merely serving your upper management is not a sound long-term strategy.
Surowiecki gives a ton of examples of the different crowds that companies serve, and how some of them serve those crowds well (Google, for example, in internet search) and some fall behind (Yahoo, in that same market). The crowd eventually moves to the superior product, no matter how much “inertia” one has.
Here, Surowiecki gets around to the concept of markets – and particularly bubbles. Much has been written about investors going crazy, following the herd straight off of investing cliffs, and many of us have witnessed it with the dot-com bubble going pop in 2000 along with (arguably) the current housing market.
Surowiecki analogizes such bubbles with a riot. In other words, bubbles are the result of people throwing out basic rules of the situation based on unexpected information or environment changes. In the case of the tech bubble, it was the rapid rise of the world wide web as a communication forum. In the case of the housing bubble, it was the lowering of housing rates combined with a loosening of lending restrictions by the government.
When sudden, significant changes happen, people are much more likely to start ignoring well-established rules and guidelines for how to behave. They begin to tip over cars or invest in things without looking at fundamentals. The best way to avoid bubbles is to just shut your ear to the hype and keep looking at the fundamentals. In other words, when others are rioting in the streets, it doesn’t mean you have to.
The book closes with a brief chapter on democracy and how we make public policy decisions. Surowiecki concludes that democracies don’t always make the best choices for the reasons alluded to above – insufficient information, or excitement over new information.
However, he also argues that given enough time, democracies will always make good choices and revert from bad ones, and that’s a hope that I think we all hold for the future.
Buy or Don’t Buy?
The Wisdom of Crowds is a brilliant one for making you think about how people behave in crowds. Why do we tend to all follow basic unwritten rules? Even more interesting, why do we often come to conclusions based on groupthink?
Surowiecki’s book is quite enjoyable and interesting on its own, but it’s one of those rare books that really launches the mind to think about things in a different way. My perception of groupthink used to revolve around an idea that it was usually wrong. Now, I see it more as a crowd dealing with insufficient information or trying to learn how to dea with unexpected information. The key? Give it time. Bubbles pop and the crowd’s wisdom eventually appears.
How can we apply that logic in everyday life? Don’t buy the “it” toy for Christmas – wait a year and see if your child still wants it. Keep trying new things, even if your friends have already established the “best” restaurant. In other words, realize that the crowd is wise, but sometimes exuberant and operating with insufficient information.
This is a great book – it’s definitely worth your time to check it out from the library. It’s one of those rare books that can authentically and profoundly change the way you perceive the world, and those books are always worth reading, whether you agree with them or not.