The power that is held within large groups of people is phenomenal. This topic has been widely discussed, most famously with the publishing of ‘The Wisdom of Crowds’ in 2005. Economics is all about predicting and analysing the behaviour of the masses so it is important to understand the collective knowledge that they hold.
In the early twentieth century there was an experiment in which hundreds of people were asked to guess the weight of an ox. Some people guessed too high and others guessed too low. However, what was incredible is that the average was almost exactly right. The actual weight was 543.4 Kg and the average estimate was 543.0 kg. This shows that although many of the individual guesses were incorrect, the overall accuracy of the crowd was impeccable.
This can be used to explain how the market value of assets are created or how the value of a share is determined. Some people value a share too highly, although others will value the share too low. If enough people, however, have an opinion on the share than the average value is likely to be the real value. Well then how does the stock market get it wrong? It is true that sometimes the value of a share is completely over or under estimated. This occurs due to what happened next, as I read in an article written by John Kay, the Financial Times.
As the competitions to guess the weight of the ox became more and more popular, people began to cheat. They looked for insider information from the farmers about the condition of the oxen. Eventually they had to make the game fairer and the farmer posted all the information about the oxen so that everyone had equal knowledge. This, however, did not benefit the competitors. Although the range of guesses was much reduced, the accuracy declined. The average guess was now not close to the actual weight of the ox.
It would seem as though the knowledge of the crowd was reduced when individuals gained more knowledge. This may be because not everyone was able to interpret the information in the same way. Some may have used it effectively and therefore improved the accuracy of their guesses whereas others drifted away from the truth.
An interesting issue is raised by this discussion. How can we know when the information we are given starts to skew our own ideas away from the truth? I think that we have to take holistic approach and give equal weighting to our own ideas as well as the knowledge provided and the ideas of others.