Harnessing the Wisdom of the Crowd

OCTOBER 2, 2019

Humans are sociable creatures who operate in crowds. Recent research has helped illuminate the traits and tendencies that separate good crowds from bad.

By Michael Kozlov and Radoslav Valkov

WorldQuant, LLC 1700 East Putnam Ave. Third Floor Old Greenwich, CT 06870 www.weareworldquant.com 10.02.19 HARNESSING THE WISDOM OF THE CROWD PERSPECTIVES

“Always remember that the in the final analysis, the kind of government we get depends upon same crowd that applauds how we fulfill those responsibilities.” your coronation is the same Today we recognize the power of crowds in politics and in fields like finance and economics. When we talk about the ability of markets crowd that will applaud to efficiently process information, to serve as a guide to future prices or to form destructive bubbles, we are talking about the your beheading. People paradoxes of crowd power. Over the past few decades, the study of like a show.” crowds has emerged as a fascinating and relevant research subject. This article will explore what we’ve learned about crowds and their behavior in different contexts, what constitutes their successes and ――Fantasy novelist Terry Pratchett, failures, and what drives them. Going Postal, 2004 What, exactly, is a crowd? A crowd is a group of people who gather together for some purpose. A crowd may be defined through that THIS IS A STORY ABOUT CROWDS THAT BEGINS IN ANCIENT common purpose or set of emotions, and it may include partisans Greece and continues today. The city of Athens, named for at a political rally, fans at a sporting event or the audience at an Athena, the goddess of wisdom, is considered the world’s opera. Crowds don’t necessarily have to be gathered physically first true democracy, with thousands of Athenian citizens together, like the Athenian assembly on the hill of Pnyx. Modern (men of a certain age) actively participating in the city-state’s mass communication and social media attract virtual crowds decision-making. Athens built an empire throughout the of many kinds, and markets are no longer confined to physical eastern Mediterranean in part because of the democratic exchanges. There are many different kinds of crowds: an aggre- inclusion of its citizens in governance. This meant that in gation, audience, group, mob, populace, public, rabble or throng. many cases the best ideas could be implemented in policy Each of these has a slightly different purpose and characteristics. through the collective wisdom of the crowd. And it ensured Generally speaking, a crowd arrives at decisions regarding action that a committed mass of citizenry had a deep investment in — in what way it will be taken and how quickly — even if only a the state’s interests, particularly in matters of war. few of its members have the necessary information about the goal or purpose of those actions. That, at least, was the theory. The reality was more complex. This same informed Athenian population also charged, convicted A crowd consists of individuals. Crowds can be characterized by and executed the philosopher Socrates and exiled the general how effectively they can make judgments and decisions. A “good” Thucydides after he was defeated in battle. In fact, the Athenian crowd is able to make fair, unbiased, rational decisions, even in assembly, consisting of all of the city-state’s male citizens, drove cases where there is a deficiency of information. (Decisions may out almost every gifted general at one time or another. During this be unbiased and rational without necessarily being correct.) A period, Athens found itself embroiled in a series of wars against “bad” crowd may lack some important aspect, such as diversity a coalition led by Sparta; eventually, this led to Athens’ defeat and or independence, and may produce wrong, even disastrous, judg- the loss of much of its empire. The greatest analysis of Athens’ ments; a bad crowd may demand conformity. An “ugly” crowd ruinous military campaigns was written by that former general reacts unpredictably, with, probability-wise, a fat left tail. Thucydides in his History of the Peloponnesian War. Thucydides, not surprisingly, was no fan of Athenian democracy. Generally speaking, a crowd arrives Still, Thucydides and other contemporary observers, including Aristotle, argued that the Athenians’ singular democratic culture at decisions regarding action even if ensured resilience from catastrophes, even those caused by the only a few of its members have the assembly’s decisions. That paradox captures the nature of democracy — and the broader subject of what is known today as the necessary information about the goal wisdom of crowds. Collective wisdom is the body of knowledge or purpose of those actions.. and principles that develops within a society and may be unleashed by democracy. As President John F. Kennedy once said, “For, in Today, in our data-driven, digital world, and despite large physical a democracy, every citizen, regardless of his interest in politics, distances, everyone on Earth is connected to everyone else by up to ‘holds office’; every one of us is in a position of responsibility; and, six degrees of separation.1 The growing density of human networks

makes actual social distances much smaller. The degree to which otherwise be absent and because it takes away, or at least weak- informed members can affect a crowd depends on their position ens, some of the destructive characteristics of group decision within the group, with those in the crowd’s core likely to have a making.” greater influence. An interconnected world generates enormous amounts of data. Increasingly, people aim to make use of this data Diversity refers to individuals in the crowd having access to pri- to improve the quality of life, and aggregation is one way to do that. vate information, even if it’s just an individual interpretation of But what data is actually useful? How do we effectively aggregate commonly known or accepted facts. To be independent is to be data? These are fundamental questions that the study of crowds free of undue influence by others in the use of that information. may well help to illuminate. “Collective decisions,” writes Surowiecki, “are most likely to be good ones when they’re made by people with diverse opinions reaching independent conclusions, relying primarily on their private “The intelligence of that information.” Surowiecki defines decentralization as a situation in which “power does not fully reside in one central location, and many creature known as a crowd of the important decisions are made by individuals based on their is the square root of the own local and specific knowledge rather than by an omniscient or farseeing planner.” Decentralization allows individuals to specialize number of people in it.” and draw on local knowledge. Aggregation is the mechanism that turns individual judgments into a collective decision. The collective ――Terry Pratchett, Jingo, 1997 group operates best when it’s fair and capable of encouraging broad-based trust among decentralized strangers.

The study of crowds is a subject within the social sciences. Scott Research routinely attributes the superiority of crowd averages Page’s book The Difference: How the Power of Diversity Creates over individual judgments to the elimination of the kind of noise Better Groups, Firm, Schools, and Societies makes the case that the associated with cognitive biases — an explanation that assumes effectiveness of crowds depends on diversity — not what we appear the independence of individual judgments. Thus, a crowd tends to be from the outside but what we look like from within (that is, to make its best decisions if it is made up of diverse opinions of our individual abilities and tools).2 Page, a University of Michigan individuals operating independently. Page formulates a kind of professor of complex systems, political science and economics, diversity prediction theorem: “The squared error of the collective argues that progress and innovation may depend less on lone prediction equals the average squared error minus the predictive thinkers with high IQs than on a diverse group of people working diversity.” Simply put, that means the greater the diversity, the together and capitalizing on their individuality. lower the collective prediction error.

James Surowiecki, author of The Wisdom of Crowds, agrees with The degree to which informed Page on the importance of diversity. Decisions resulting from the aggregation of information in groups, he writes, are often better members can affect a crowd depends than those made by individuals.3 Surowiecki, a financial writer for on their position within the group, with the New Yorker, focuses on both diverse groups making independent decisions and manifestations of crowd psychology, such as those in the crowd’s core likely to have herding, in which clusters of individuals follow the larger crowd. a greater influence. The argument for “good” crowds is that a diverse collection of individuals deciding independently is likely to make certain types Averaging can eliminate random errors that affect an individu- of judgments and predictions more effectively than individuals al’s answer, but not systematic errors that affect the opinion of — even individual experts — alone. This process has many par- the entire crowd. Therefore, an averaging technique could not be allels with statistical sampling, in which you try to understand the expected to compensate for cognitive biases that drive a crowd to general tendencies of a larger population by choosing a smaller, act or react in a certain way. representative sample. PRACTICAL APPLICATIONS Surowiecki posits that five elements are required to form a wise Research into the study of crowds has applications in three broad crowd: diversity of opinion, independence, decentralization, aggre- categories. The most common application is the so-called pre- gation and trust. Having a diverse group of decision-makers, he diction market: speculative or betting markets created to make writes, “helps because it actually adds perspectives that would verifiable predictions. For example, Dublin’s Paddy Power Betfair,

a unit of bookmaker Flutter Entertainment, is the world’s biggest The most striking example of a crowd failure is the rational bubble. prediction exchange. Prediction (or information) markets ask ques- In this situation, collective cognition and cooperation fail because, in tions like, “Who do you think will win the election?” and they predict one way or another, members of the crowd grow too conscious of the outcomes rather well. Individual answers to the question “Who will opinions of others and begin to emulate one another and to conform you vote for?” are not as predictive. Prediction markets interpret rather than think independently. John Maynard Keynes identified current market prices as the probability of an event occurring or this as an aspect of markets in his metaphor of investors as beauty the expected value of a parameter. Assets are cash values tied to pageant judges who try not to pick the most beautiful contestant specific outcomes — for example, that a certain candidate will but the one the other judges would choose. When independence win the election — or parameters, such as next quarter’s revenue. declines, imitation and herding kick in and diversity vanishes

The second application is the so-called Delphi method, developed While there is merit to the idea that the many are smarter than the by Rand Corp. in the early 1950s. This is a systematic, interactive few, it is not always true, particularly when members of a crowd forecasting method that relies on a panel of independent experts. are aware of and overtly influenced by one another’s opinions. Carefully selected experts answer questionnaires in two or more Consensus thinking among a group with poor judgment can lead rounds. After each round, a facilitator provides an anonymous to disastrous group decision-making. This factor may have been summary of the forecasts and reasoning from the previous round. among the causes of crises ranging from the 2008 financial melt- Participants are encouraged to revise their earlier answers in light down to Athens’ defeat in the Peloponnesian wars. of the views of other members of the group. During this process, the range of the answers tends to narrow and the group converges MARKETS AS CROWDS toward a “correct” answer. Many of these consensus forecasts have In a 2015 column, wealth manager and columnist Barry Ritholtz proved to be more accurate than predictions made by individuals. argued that, unlike markets for equities and goods and services, prediction and futures markets lack the wisdom of crowds because Third, human swarming is an optimized method for unleashing the they do not possess a large or diverse enough pool of participants.5 wisdom of crowds. This approach implements real-time feedback He pointed out that prediction markets failed spectacularly in trying loops around synchronous groups of users, with the goal of achiev- to guess the outcomes of events such as Morgan Stanley CEO Philip ing more-accurate insights from lower numbers of people. Human Purcell’s 2005 resignation and the 2015 Greek referendum on a swarming is modeled after biological processes in birds, fish and European Union bailout. Individuals trying to predict the outcomes insects, with a network of users employing a mediating software, of these events were simply guessing, based on public polling data, such as the UNU collective intelligence platform. Such real-time and lacked any special individual or collective knowledge. control systems allow groups to behave as a unified collective intelligence. In fact, we may think of financial markets in much the Research into crowds also explains what makes markets effi- same way, as much a part of nature as beehives or ant colonies, in cient at some times and inefficient at others. Strong efficiency is which swarm intelligence arises despite individual agents not fully a chimera, but the efficient market hypothesis, which states that understanding the rules distributed among them all.4 prices incorporate all available information on an asset price, is somewhat true in its weaker form; that is, all existing information When does collective intelligence fail? Centralization can lead is not yet assimilated but will be assimilated by the market. That to biased results and cripple collective intelligence when deci- information, in turn, will promptly remove imbalances — a pro- sion-making is not open to individual judgments and the benefit cess known as statistical arbitrage — and rationalize a security’s of aggregating unique private information is lost. Another source or product’s price. of failure: errors in sampling, in which you sample from a different distribution from the one that really exists; this can produce collec- When this process breaks down, markets will be less efficient and tive hysteria. And when the crowd is homogenous, its intelligence prices will separate themselves from value. That’s often the case may be biased. Diversity helps ensure there is variance in approach, with rational bubbles; peer pressure, imitation and herding vaporize thought processes and private information. diversity and independence. Markets may crash after an asset bubble bursts, when investors fully realize the unsustainability of market Surowiecki posits that five elements prices. That’s when panic sets in and market liquidity evaporates.

are required to form a wise crowd: Portfolio diversification is the most powerful tool to reduce risk, diversity of opinion, independence, but it is simply not enough to protect investors from a systemic failure.6 When investors start pulling money out of highly leveraged decentralization, aggregation and trust. hedge funds, the latter are forced to liquidate large portions of

Research into crowds also explains through interlocking crowds — markets. The crowd shapes every corner of human life, from a range of social activities, including what makes markets efficient at some democratic politics, to financial markets and even to advanced times and inefficient at others. techniques like machine learning. their portfolios at the same time. The withdrawal of liquidity and But crowds, like the individuals that make them up, are imper- the unwinding of leverage hit all asset classes except government fect. When certain conditions in the crowd ecosystem are met bonds and cash, which can provide real diversity. — diversity, independence and the ability to tap private information — crowds can act with intelligence, even wisdom. When these Yet, for much of the time, markets may appear, through active conditions are limited or eliminated, crowds can become foolish, and rational arbitrage, to be relatively efficient. As proponents blind, even dangerous. In a homogenous crowd, cognitive biases of the wisdom of crowds argue, a sizable amount of individual can undermine the predictive power of crowdsourcing. A crowd irrationality is canceled out in the totality of judgments made in that has been seized by emotion, that has lost its ability to think markets. Although markets may not be fully efficient, they are and judge, may turn lethal. a kind of continuous voting mechanism that passes a stream of verdicts on consensus value. The crowd is constantly evolving, just like humanity itself. Given our human nature, our individuality married to a need to engage socially, CONCLUSION we really have very little choice but to operate in crowds. The way Crowd behavior is a fascinating phenomenon, which is omnipresent may be difficult, but harnessing the wisdom of the crowd may be in our world despite its elusive qualities. From ancient to modern the only path to a happy, prosperous and successful society. ■ times, consciously or not, we have judged, negotiated, operated and lived in crowds. Humans are sociable creatures, and crowds Michael Kozlov is Senior Executive Research Director at WorldQuant, are the waters that we swim in. We gather in groups where we LLC, and has a Ph.D. in theoretical particle physics from Tel Aviv University. communicate, analyze and make choices together, from fashion Radoslav Valkov is a Senior Quantitative Researcher and has a Ph.D. in trends to lifestyle choices to political leaders. We go to war in mathematics from the University of Antwerp. crowds, and we make peace in crowds. Our economy functions

ENDNOTES

1. Frigyes Karinthy. Láncszemek (Chain-Links). 1929. 4. Igor Tulchinsky. The UnRules: Man, Machines and the Quest to Master Markets. Hoboken, NJ: John Wiley & Sons, 2018. 2. Scott E. Page. The Difference: How the Power of Diversity Creates Better Groups, Firm, Schools, and Societies. Princeton, NJ: Princeton University Press, 2007. 5. Barry Ritholtz. “The ‘Wisdom of Crowds’ Is Not That Wise.” Bloomberg (July 7, 2015). 3. James Surowiecki. The Wisdom of Crowds. New York: Doubleday, 2004. 6. John Plender. “The Flawed Wisdom of Crowds.” Financial Times (June 16, 2009).

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