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Monday, September 20, 2010

The wisdom of crowds, the madness of crowds

by John MacBeath Watkins

Two titles for today:  The Wisdom of Crowds, by James Surowiecki, and Extraordinary Popular Delusions and The Madness of Crowds by Charles MacKay.

Can crowds be both wise and mad?  Well, yes.  I look to the metaphor of the ant colony and the ant mill.

Naturalists have long been fascinated by the self-organization of ant colonies, all the more impressive because individual ants aren't all that bright.  For example, when they find a source of food, they quickly start a line of ants transporting it by the most direct route.  How do they do that?

Well, each ant lays down a scent trail.  The pheromones that make up the scent fade fairly quickly, so the ants tend to follow the more recent trails.  As a result, the original track followed by the ant that first found the food is not the one they all follow.  It followed its own scent back to the nest and led the other ants along its trail, but the other ants sort of cut the corners, making a trail that is a little closer to being straight, and those following them also cut the corners, and those following...you get the idea.  Pretty soon the track to the food is straight.

An ant mill occurs when a group of ants get split off from the main party.  This is usually observed with army ants, which march forth as a colony looking for lebensraum and foraging for supplies.  A group splits off, and the lead ants of the splinter group have lost the trail, so they go looking for a scent trail to follow.  Going in a circle, they come upon the trail of their own group.  They then might follow that trail back to the main body, or follow the ant trail of their own group in a circle.  The fresher scent will be that leading them in a circle, and the more that follow the circle, the fresher this becomes.  Soon, the group of ants is walking determinedly in a circle, and continues to do so until they die of exhaustion.

The very thing that made them seem wise has made them seem mad.

Humans are more complex than ants, but it's not a bad metaphor.  The 'wisdom of crowds' refers to the fact that if, say, you ask many individuals how many jellybeans are in a jar, most people will give you an estimate that doesn't come close, but the average of all the judgments will be surprisingly accurate.

Sometimes, though, this fails to happen.  MacKay's 1841 book focused on events like the South Sea Bubble of 1720 and the Dutch Tulip mania that peaked in 1637.  In both cases, people saw something increasing in value and didn't want to get left behind.  Eventually, a single bulb for a particularly sought-after tulip was selling for a price that would have bought a farm.  Instead of following a signal that took them to the mean, investors were following signals from other investors that took them away from the actual value of the object being traded.

Markets are supposed to arrive at a value based on the wisdom of crowds; some people thinking a thing is worth more, some less, but soon those who charge too little have no product and those who charge too much have no customers, so each follows the signals to the proper value.  In a bubble, people don't buy based on the value of a thing for use, they buy based on the assumption it will appreciate.  Of course, if you recognize value others don't, you really can make money on such an assumption.  In a bubble, too many people think they've found such an investment, and as the value keeps going up, investors follow the signal that there is something of value here, until, like the ant mill, it will obey Stein's Law: If something can't go on forever, it will stop.

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