Wisdom of crowds - a puzzle

Is belief in the wisdom of crowds self-defeating? This is one question raised by the "slump."
Put yourself in the position of an intelligent investor back in the spring. You know that the yield curve is a vastly better economic forecaster than economists are, and its inversion signals that a recession is quite likely. You know too that  there's a good correlation between industrial production and equity returns. So you're tempted to dump shares.
But then you remember the wisdom of crowds. Surely, you figure, the fact that the crowd - not just of economic forecasters but of other investors - isn't thinking of recession shows that one isn't likely. And the market must be discounting the possibility  anyway: price-earnings ratios were quite low back then.
So, you decide not to sell.
In this sense, belief in the wisdom of crowds proved self-defeating. In believing the crowd was right, you didn't sell shares. The upshot was that shares were left over-priced, because some information about the likelihood of recession - the opinions of those who believed both the yield curve and wisdom of crowds - could not be embodied in prices.
Because some people thought crowds were wise, the crowd - the stock market - proved not to be so.
Now, this doesn't show that the wisdom of crowds is logically incoherent. Its advocates accept that one condition for crowds to be wise is that individuals' beliefs be independent, uncorrelated. Which is exactly the condition violated in this case.
What it does mean, though, is that the idea's relevance might be greatly limited in practice.
The problem here is not the same as the well-known paradox of efficient markets - that if everyone believed markets were efficient, no-one would bother exploiting price-relevant information and so markets would be inefficient.
In that case, information lies around, but is unused.
In the case of the wisdom of crowds, information is actually destroyed - the bearish beliefs of those who expected recession were reduced by their belief in the wisdom of crowds. In this sense, belief is the wisdom of crowds is positively damaging.

Comments

[Matthew]

Perhaps they read that paper on yield curves, saw it was by two Fed officials and assumed therefore the Fed would slash interest rates early and save the day?

[Matthew]

Actually surely the point is what's your rule? The yield curve went negative in about July 06. If you'd have sold the S&P then at 1246, you'd have missed out on a huge gain up to 1550, and even now it's 5-10% higher than that.

[Matthew]

Here's a chart directly comparing the yield curve (10yr less 3-month) with the S&P 500, which might be more fruitful than indirectly looking at it through the performance of the economy

http://www.flickr.com/photos/mjtphotos/2211840275/

Note the S&P is inversed and also not % change but just the index.

Seems that the S&P was ahead of the yield curve (in its turning point) in 2000, behind this time.

[ramster]

It's funny because I was thinking precisely along those lines too in the spring. I'm a young, small time (low 6 figures) investor of my retirement funds and I find the whole efficient markets thing quite compelling, yet most of my money is in a fund that's pretty much the exact opposite (focused stock picking combined with macroeconomic driven strategy)...which has had an annual return of almost 30% for 10 damn years!

So in the spring, I'm thinking that if I really believe in efficient markets, I should sell all my holdings in this fund and put it all in indexes. But it's soo hard to sell such a killer performer, especially when it feels like they're getting the awesome performance because they're good, not just lucky (but how can you be sure?)

And as a regular reader of Roubini, I had recession on the brain all year. But EM says he's full of it. So what to do? I ended up selling half my holdings at the 2007 peak in the spring and it's sitting in cash. So I ended up trying market timing...which is precisely what everyone tells you NOT to do. I'm glad I did it though.

[Sean Morris]

out of shares in july 07, and into gold in august 07, which makes a change as I was stuck on a beach in the pacific for 3 months in 2000 and failed to act when I needed to act, so at last I am happy, the longterm has come to my aid.

I think WoC is generally correct as long as everyone in the information market place are playing to the same rules. when it comes to money if you have a piece of information that can make you richer you tend to keep your mouth shut, thus Mavens or market place leaders of information tend to speak up later rather than sooner in money markets.

Economics was never and never will be a science, as we know price theory is junk, so its all a matter of guess my guess of the price.

my contribution to the WoC for the coming year(s). A soft landing will be dependent on tax cuts and fiscal tightening not interest rate cuts, in 2008 inflation is back, so its a question of cashing in on the errors of politicos interfering/distorting the market place, this is not the time to be printing yet more money, what is needed is real money chasing real returns, not overvalued money chasing get rich quick property schemes(or guess my guess pricing)

[Chris Williams]

Here's another example of the wisdom of crowds. Lots of people thought that the following were a reasonable set of predictions for the likely result of a football match:

http://www.valuechecker.co.uk/113585489.htm

Perhaps one team's back four trusted to the wisdom of crowds and put too much faith in these odds, thus leading to a result that fell far outside the predictions.

[donna]

You certainly saw Buffett and others getting out, then. A lot of us switched at least some investments into diversification also, or into cash.

[reason]

Brilliant post. But isn't this the whole thing about rational expectations. Rational expectations become self-fulfilling, until they are eventually and inevitably hopelessly out of line, and a crash occurs. Rational just means following the model du jour. I defy anybody to prove that the model is NOT dictated by rational expectations, since rational expectations is whatever the market thinks will happen. Perfectly circular.