Polar Sun Research

QuoteCrowd Behavior in Prediction, Betting, and Stock Markets

Introduction

In 1932, Bernard Baruch, a wealthy financier who made his fortune on Wall Street in the early 20th century, contributed the foreword to a reprint of the 1852 edition of Charles Mackay's classic book on markets, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds.

Invoking a dictum from Friedrich von Schiller, a German poet and philosopher, Baruch wrote: "Anyone taken as an individual, is tolerably sensible and reasonable—as a member of a crowd, he at once becomes a blockhead." He added, "Without due recognition of crowd-thinking (which often seems crowd-madness) our theories of economics leave much to be desired."

About 40 years later, Eugene Fama, a professor of finance at the University of Chicago and a winner of the Nobel Prize in Economics, published "Efficient Capital Markets: A Review of Theory and Empirical Work." It is among the most famous papers ever written in finance. This might be considered the theory Baruch had in mind. Fama posited, "A market in which prices always 'fully reflect' available information is called 'efficient.'"

Fama found that strategies investors commonly applied to try to outperform the market, including using past price patterns to project the future and doing fundamental analysis to distinguish between price and value, failed in their objective. In other words, there is no reliable way to take advantage of the blockheads.

Nearly all those who study markets carefully agree that they appear sensible for the most part, as theory would have it, but periodically go bonkers.3 Having one framework to accommodate both realities is useful.

James Surowiecki wrote about such an approach in 2004.4 Riffing on Mackay's madness of crowds, Surowiecki called his book, The Wisdom of Crowds. He showed that crowds can be remarkably accurate in reflecting objective values or outcomes. Indeed, the prices generated by collectives commonly converge on the proper theoretical price in experimental settings. This thinking runs against the idea that individuals are reasonable and crowds mad.

But key to Surowiecki's case is that the wisdom of crowds depends on satisfying certain conditions. When those conditions are in effect, crowds are generally wise. When one or more of those conditions are violated, crowds can be mad.

This report specifies those conditions, identifies various types of problems, and examines how they apply to prediction markets, sports betting, parimutuel betting, and the stock market. The goal is to see how the conditions function in each market, and where they are the same or different for each.

These concepts are useful for investors for a few reasons. First, the wisdom (and madness) of crowds is a sound way to explain market behavior. Practitioners have had a sense of this for centuries and academics now take the idea seriously.6 Second, prediction markets provide real-time probabilities for events that may be helpful to investors.

Finally, the conditions for collective intelligence apply within organizations as well, which has relevance for hiring and training employees as well as structuring meetings and making decisions. There remains a large gap between what research reveals as best practices and what most organizations actually do.