I would imagine that most if not all of you have heard of the theory of The Wisdom of Crowds; the idea that the views of a large group are more reliable than those of an individual. It forms the basis of a book of that name by Surowiecki.
In trading, The Wisdom of Crowds (WoC) is often referred to as a core reason behind the use of certain trading styles. Supporters of trend trading and many forms of technical analysis often use WoC as a justification for their technique. It could be argued that one of the main assumptions behind technical analysis, The Market is Ahead, at least partly has its roots in the idea of the wisdom of the collective.
We are told to follow the crowd (trend) because the collective makes smarter judgements that we can as individuals.
Before we start to incorporate WoC into our trading we should first define what it means.
Ask people to define WoC and many would answer like this:
There is a buffalo in a field and we ask 1,000 people to guess the weight of the buffalo. WoC suggests that the average guess of the whole group will actually be quite accurate and significantly more so than that of any particular individual. Essentially, the collective is far smarter at solving these puzzles than an individual.
If this were indeed the definition of WoC then it would be a very useful concept for traders.
But it isn’t.
There is one crucial element missing.
WoC requires all of the individuals to make independent guesses. That is, each person does NOT know what the others are guessing.
Why is this important?
Imagine we were going to question 1,000 people about the weight of the buffalo but rather than each person making a blind (independent) guess, we were going to ask them to stand up one at a time and tell everyone their answer.
Let’s say the first person gets up and says “1,000kg”.
Now person number two was going to guess 300kg but having heard the first answer do we still think person two will make the same guess? It is very likely that person two will be influenced by person one and may change her guess, perhaps to 400kg, maybe even higher.
This in turn will influence person three and so on….
The process outlined above is completely different to one where all guesses are made independently/privately and will deliver completely different results.
Where people know the guesses of others they will be prone to a number of biases such as anchoring (using the guesses of others as an anchor for their own) and peer pressure and the desire to fit in with the crowd.
The independent process eliminates these biases and is a much more robust process.
Why is this important for traders?
We must recognise that in the markets we can see everyone’s guesses. Trading prices, whether we see them on a chart or in other forms such as time and sales, are other people’s guesses.
So markets do not work on an independent guess basis. They will be prone to biases such as anchoring.
Therefore WoC does not and cannot apply to trading.
So we should not use trading styles or methods that rely on WoC.
There are so many pieces of ‘wisdom’ that are routinely accepted without much questioning and using WoC in trading is one of them. If the idea sounds plausible and is commonly stated (and perhaps fits with a person’s bias) it can be easy for people to just accept it is true. In trading, so many pieces of ‘accepted wisdom’ are in fact found to be untrue or unreliable when investigated further; WoC is one of those.