The Dow and the wisdom of the crowd

Then and Now

The Dow Jones Industrial Average is making record highs, knocking the 2007 peak off its pedestal, but investors aren’t celebrating.

Since the Dow hit its March 2009 low, many sage market players followed the stimulative monetary and fiscal policies, ignored the noise of pundits predicting doom and gloom, and invested heavily in equities. Only in retrospect can their bold calls be recognized as wise.

I often look to social sciences and psychology to help investors understand the importance of the collective genius. In one of my favorite books, The Wisdom of Crowds, James Surowiecki points to statistics scientist Norman L. Johnson’s maze experiment as one of many illustrations of intelligent group decisions.

Johnson sent groups of people one-by-one through a maze, recorded their paths and timed the results. Do participants take a left or a right? How many steps does it take to make it through?

Then, he calculated how many total steps each individual took to reach the end of the maze. The average ended up to be 12.8 steps, but the group collectively did much better, taking only nine steps. More importantly, “there was no way to get through the maze in fewer than nine steps, so the group had discovered the optimal solution,” wrote Surowiecki.

Time and time again, Surowiecki found evidence of collective decisions to be superior to individual results, whether researchers asked people how many jelly beans are in a jar or how much an ox weighs. The “collective guess was very accurate, and was better than the vast majority of individual guesses.”

This collective wisdom theory was also used to predict the winner of elections. Nate Silver of The New York Times’ FiveThirtyEight blog analyzes data on state and national polls along with economic information, including GDP, jobs and inflation. His interests in playing poker and writing about baseball made him adept at studying statistical means, odds and probabilities, and his prediction model results are phenomenal. During the 2008 presidential election, Silver correctly predicted 49 out of 50 states correctly. And in last fall’s election, he correctly forecasted the electoral outcome in all 50 states.

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