The Wisdom of Crowds: Bubbles and Crashes

notes from Surowiecki, James. The Wisdom of Crowds. (Anchor: 2005)

Bubbles and crashes are textbook examples of collective decisionmaking gone wrong. In a bubble, all of the conditions that make groups intelligent — independence, diversity, private judgement — disappear.

You don’t see bubbles in the “real” economy — they’re essentially a phenomenon of financial markets. When you buy a stock, you’re also buying the right to resell the stock. When you buy a product, you also get that right to resell, but that’s not where the value of the product lies for you — the value is more in its utility to you. Because of this, physical products tend to lose value over time. Stocks and other financial market products, on the other hand, tend to gain value over time. The market’s opinion of that value is what matters — what does everyone think it’s worth?

The price of a stock relies on dependent decisions — people are concerned with not only what they themselves believe it to be worth, but also with the value everyone else gives it. John Maynard Keynes (in an analogy that was perhaps more acceptable in the early 20th century than it is now) called this process the beauty contest model:

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of other competitors, all of whom are looking at the problem from the same point of view.

The competitors are not working totally independently — they have to recognize the importance of everyone else’s opinions, and try to predict what they will be in order to win the competition.

Bubbles and crashes occur when the mix shifts too far in the direction of dependence. A crash is simply the inverse of a bubble, although it’s typically more sudden and vicious. In a crash, investors are similarly uninterested in the “real” value of a stock, and similarly obsessed with reselling it.

An experiment done at CalTech simulated the conditions leading up to a bubble —

In the experiment, students were given the chance to trade shares in some imaginary company for fifteen five-minute periods. Everyone was given two shares to start, and some money to buy more shares if they wanted. The trick was that each share paid a dividend of 24 cents at the end of each period. If you owned one share at the end of the first period, you’d be given 24 cents. If you owned one share for the entire experiment, you’d get $3.60. So before the game started, if someone asked you how much you’d pay for a share, the correct answer would be “No more than $3.60.” After the first period, you’d be willing to pay no more than $3.36. After the second, you’d pay $3.12. And so on.

The point of all this is that there was no uncertainty about how much each share was worth (as there is in a real stock market). If you paid more for a share than the amount you were going to collect in dividends, you overpaid. Yet when the experiment was run, the price of the shares jumped immediately to $3.50 and stayed there until almost the very end. When the shares were worth less than $3, people were still exchanging them for $3.50. As the value of the shares dipped below $2, the price did not drop. And even when the shares were worth less than $1, there were still people shelling out $3.50 to pick them up.

What were students thinking? Economics Colin F. Camerer, who designed the experiment, asked them why they bought at prices they had to know were crazy: “They’d say, ‘Sure I knew that prices were way too high, but I saw other people buying and selling at high prices. I figured I could buy, collect a dividend or two, and then sell at the same price to some other idiot.’ ” In other words, everyone was convinced the greater fool was out there.

News reports do some strange things to the way information is spread and received in markets. They “overplay the importance of any particular piece of information,” which can cause overreactions and destroy the “private information” that’s so important in successful collective decisionmaking.

The media often exacerbates — though it doesn’t cause — the feedback loop that gets going during a bubble. It’s already hard enough, as we’ve seen, for investors to be independent of each other. During a bubble, it becomes practically impossible. A market, in other words, turns into a mob.

 

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