James Surowiecki: The Wisdom of Crowds

In the last post we talked about Intrade, which (along with other online betting and prediction sites such as Newsfutures) has a novel manner of predicting the future: letting the people decide.

A specific, factual prediction is made. If you believe it will happen, you buy shares, if you believe it won't happen, you sell shares. The prices at which you, individually choose to buy and sell reflect the strength of your conviction. The price of the stock fluctuates with each trade: essentially, the price of the stock at any given moment is the price that the latest person who bought it paid for it. That price is always between $0.00 and $10.00, and the "collective perception" of the probability of the statement's truth is 10 times the price of the stock.

The major question underlying this system is: why should we believe that a bunch of people laying bets and buying and selling stock knows anything about what's going to happen or not happen? They're not experts, what do they know?

Ah, but as it turns out, apparently they do know. Research has shown again and again that the dominant opinion of a crowd (if it's a yes or no question) or the average opinion (if it's a numerical question) tends to be closer to the truth than the opinions of individual experts, no matter how expert they may be.

For example, a 1984 study showed that the price of orange-juice futures was a more reliable weather predictor, in certain citrus-growing states, than the U.S. Weather Service forecast!

Much earlier, 19th century anthropologist Francis Galton was both surprised and impressed to discover that at a county fair guess-the-weight-of-the-ox competition, the average of the guesses of the 800 farmers present was astonishingly close to the actual weight of the ox - closer than all but a very few of the individual guesses, and closer than all of the guesses made by cattle experts present at the event. (It is said that Galton's observation greatly reinforced his faith in the system of democracy.)

But everyone knows that crowds can be swayed into wild, irrational behavior - stock market panics, lynchings, mass hysteria. So why should the wisdom of crowds be trusted?

One James Surowiecki, staff writer at The New Yorker, has developed a simple and striking theory to answer that question. According to Surowiecki, for a crowd to be a "wise crowd", it needs to have four qualities:

1) Diversity of opinion: Each person should have private information even if it's just an eccentric interpretation of the known facts.

2) Independence: People's opinions aren't determined by the opinions of those around them.

3) Decentralization: People are able to specialize and draw on local knowledge.

4) Aggregation: Some mechanism exists for turning private judgments into a collective decision.

[This table summarizing Surowiecki's theory was drawn directly from the Wikipedia entry on "The Wisdom of Crowds".]

In examples of collective error or misbehavior, at least one of the elements above is missing from the crowd; most generally "independence", as the anger behind a lynching or the panic leading to a financial crash are highly contagious.

But, based on many studies, Surowiecki demonstrates that the predictive ability of "wise crowds" is remarkable.

Estimating the probabilities of possible outcomes of factual matters is fundamental in developing strategy. So if a "wise crowd" can make some of those predictions for us, let us by all means pay attention.