Bubbles and Beauty Contests

Finally got down to reading James Surowiecki’s The Wisdom of Crowds, which I was supposed to have finished a year ago for my Public Finance class. Its thesis, in a nutshell, is that when you aggregate a diverse set of perspectives, the collective decision is often far superior to even the smartest individual in the group. While the entire book is amazing, chapter 11 is by far my favorite because it talks about financial markets.

Markets seem to be Surowiecki’s favorite vehicle for collective decision-making. And rightly so: they’re an excellent medium for aggregating the vast opinions of diverse individuals, and a market’s collective decision –the price – is almost always an accurate predictor of the true value of the asset.

However, as Surowiecki points out, financial markets are curiously inefficient. There’re so many great things to talk about in this chapter but I’ll try to zero in on his main points:

1) The nature of financial markets. Financial markets thrive on dependent, (as opposed to independent) decision-making. Keynes compared financial markets to a beauty contest where everyone had to pick out the six prettiest faces from a hundred photographs, and the winner was the one whose choice corresponds closest to the average preferences of everyone else. In short, an investor is concerned not just with what the average investor thinks but with what the average investor thinks the average investor thinks, and so on. When everyone makes their decisions based on the decisions of everyone else, this makes the market “stupid”, leading to inefficiencies such as bubbles and crashes.

2) How bubbles form. Bubbles and crashes happen because of the dependent nature of markets. Bubbles, in particular, are unique to financial markets because most people are buying a stock hoping to resell it to the “greater fool” (or the more optimistic one). Surowiecki points to a Caltech experiment that shows that a bubble forms even though everyone knows that they are in the midst of one. Everyone is convinced that the greater fool was out there. Also, would any sensible money manager be able to resist sitting out of the Nasdaq boom of the late 90s when everyone was making returns of 40 – 85%? As a result, everyone piggybacks and mirrors each other.

It is here that Surowiecki points out that for all the antipathy directed against short sellers (investors betting that the market would go down) for causing the current financial crisis, the truth is that the presence of short sellers would have prevented (or at least dampened) the bubble from forming in the first place. Short sellers help to cancel out the effects of overoptimistic investors, thus helping the market to reach its true price. However, for a number of reasons, short sellers account only for a tiny fraction of all investors, so the market is allowed to drift upward and become ever more inefficient. Which leads me to question the Obama administration’s policies on imposing all these limits on short selling – do they really know what they’re doing?

3) The role of (too much) information. Surowiecki also talks about the role that information plays in financial markets. In particular, he feels that financial news media like CNBC actually magnify the dependent nature of the stock market because “it bombarded investors with news about what other investors were thinking”. We see the effects clearly: If a CNBC analyst likes a particular stock, its price jumps mere seconds after the report is broadcast. This is hardly enough time for any investor to make an informed decision of whether the stock is a good buy. Instead, investors are jumping on the bandwagon because they know that other people are jumping on as well.

A potentially harmful effect of being bombarded with information: studies have shown that people perform poorer than if they were not given the additional information at all. More information skews the collective wisdom of the crowd, upsetting the balance between public and private information that helps crowds come to a good decision.

I highly recommend anyone studying or trading the markets to take a good read of this chapter – it’s fascinating to see how markets are not so much driven by clinical, hard facts as opposed to irrational, uncontrollable emotions.

(all the ideas in this post are the ideas of James Surowiecki and I take no credit for summarizing and rephrasing them)

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