The Wisdom of Crowds: Individual Irrationality

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

Markets work according to theory, even when real people (aka imperfect agents) are working within them, with only partial information.

Cooperation problems: can be solved even if each individual is single-mindedly pursuing his own self-interest.

People are not fully rational players — they care about what’s fair, what’s deserved. The “Ultimatum Game” experiment shows that “people will give up free money to punish what they see as greedy or selfish behavior.”

People want there to be a reasonable relationship between accomplishment and reward.

Strong reciprocity: the willingness to punish bad behavior even when you get no personal material benefits from doing so. It’s a prosocial behavior, “because it pushes people to transcend a narrow definition of self-interest and do things, intentionally or not, that end up serving the common good.”

In a market, investors deviate from the perfectly rational in several main ways:

  1. Investors herd, “preferring the safety of the company of others to making independent decisions.”
  2. Investors are fooled by randomness, believe in streaks and trends.
  3. They pay more attention to recent events than to long term implications or consequences
  4. They find losses more painful than they find gains pleasurable, so they hold onto losing stocks longer than they should.
  5. They’re overconfident.

But even though investors are irrational, aggregating their results still gets you a rational outcome. “Only those behavioral quirks that create systematic biases in opinion…do real damage to the market. Individual irrationality can add up to collective rationality.”

Anchors: “arbitrary numbers — like say the current price of a stock — that people nonetheless seize on and allow to affect the way they make choices.”

The idea of the wisdom of crowds is not that a group will always give you the right answer but that on average it will consistently come up with a better answer than any individual could provide. That’s why the fact that only a tiny fraction of investors consistently do better than the market remains the most powerful piece of evidence that the market is efficient.

With the stock market, there never is a point when you can say it’s over, never a point at which you will be proved right or wrong.

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