On The Wisdom Of Crowds (And Madness Of Mobs)

Tyler Durden's picture

Fear, like greed, makes people, and that would include investors, behave irrationally. Two major equity bear markets in the last 13 years have traumatized investors. The belief in Modern Portfolio Theory in general and the Efficient Markets Hypothesis (EMH) in particular has been shaken and finance theory will have to be re-written. So, Absolute Return Partners' Niels Jensen asks, what is it specifically that has changed? Human behavior certainly hasn’t. Greed and fear have been factors to be reckoned with since day nought. When faced with the unknown, people (in this case, fund managers) will use whatever information they can get hold of. Hence we shouldn’t really be surprised that fund managers extrapolate current earnings trends when forecasting future earnings, despite the evidence that it is a futile exercise. Occasionally, the Wisdom of Crowds turns into the Madness of Mobs and all rational behavior goes out the window. History provides many examples of that. EMH is entirely unsuited to deal with froth. What made economists love the EMH is that the maths behind it is so neat whereas the alternative truth is a little messy.



The new paradigm

Two major equity bear markets in the last 13 years have traumatised investors. The belief in MPT in general and EMH in particular has been shaken and finance theory will have to be re-written, or so it looks. So what is it specifically that has changed? Human behaviour certainly hasn’t. Greed and fear have been factors to be reckoned with since day nought. Dr. Lo, who has pioneered the research into how EMH can be adapted to incorporate behavioural factors, offers the following explanation (and I paraphrase):

The growing importance of the financial services industry, together with geopolitical changes (the U.S. is no longer the only dominant economic force in the global economy), and rapid advances in technology, have destabilised the equilibrium. The obvious implication, or so Dr. Lo argues, is that investors must change some of the tools in their tool box.

Interestingly, he doesn’t suggest that EMH should be mothballed altogether. To the contrary, he believes that EMH can work for extended periods of time provided investors behave rationally. I had the pleasure of meeting him in Cambridge (Massachusetts) a few weeks ago, and he delivered a convincing case that investor behaviour is actually rational most of the time when looked upon in aggregate. He calls it the Wisdom of Crowds and illustrated what he means with a simple example:

Imagine somebody puts a large jar full of jelly beans in front of you and you are meant to guess how many jelly beans the jar contains. You have no idea, but you are up for it, so you come up with a number. Sadly, unless you happen to be lucky, the chances are that your guess is miles off the true number. Now imagine that the same question is put to a large number of people and that the mean is calculated as the simple average of all the estimates. Interestingly, research suggests that the mean estimate is likely to be within a few percentage points of the true number. The Wisdom of Crowds.

The FT ran a story at the height of the credit boom back in April 2006 on the rapid growth of the CDO market in Europe. When asked by the FT to
comment on this remarkable growth, Cian O’Carroll, European head of
structured products at Fortis Investments, replied:

“You buy an AA-rated corporate bond you get paid Libor plus 20 basis points; you buy an AA-rated CDO and you get Libor plus 110 basis points.”

On the back of this statement, and despite all the evidence of froth in financial markets in 2005-07, it seems like the crowd was still quite wise. As Dr. Lo states in his 2011 paper:

“It may not have been the disciples of the Efficient Markets Hypothesis that were misled during these frothy times, but more likely those who were convinced they had discovered a free lunch.”

Occasionally, the Wisdom of Crowds turns into the Madness of Mobs and all rational behaviour goes out the window. History provides many examples of that - from the tulip mania in the Netherlands in the 17th century to the more recent bubbles we have experienced in dot com stocks and housing markets around the world. The once golden boy of central banking, Alan Greenspan, labelled it irrational exuberance in a speech in 1996 when commenting on what already then looked like lofty P/E levels on U.S. equities. As we now know, the bull market not only continued for a further 3 ½ years; it actually grew stronger. Once the mob gets going, it takes a great deal to stop it.

EMH is entirely unsuited to deal with froth. Charlie Munger (of Berkshire Hathaway fame) once said, and I paraphrase, what made economists love the EMH is that the maths behind it is so neat whereas the alternative truth is a little messy.

Full Absolute Return Partners Letter below:

The Absolute Return Letter 0613

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ekm's picture



Talking about PROPAGANDA. Fresh, quite fresh, merely minutes ago.

fonzannoon's picture

I saw ZH tweet back about aes 256. what is that?

Tulpa's picture

Ever hear of Google?

AES = Advanced Encryption Standard

knukles's picture

Efficient Capital Market Hypothesis

                          Hypothesis (Only, as in hypothetically speaking)

Modern Portfolio Theory

                          Theory (Theory as in... ) Oh never the fuck mind...

A Lunatic's picture

........take the destruction of America for instance...........

fonzannoon's picture

That is basically what I found. "The bottom line is that if AES could be compromised, the world would come to a standstill."

How would the world come to a stand still?

PiltdownMan's picture

Interesting. What about housing? I smell a bubble, but economists say no,




lolmao500's picture

While WW3 nearly kicked off once again in the middle-east last night...


During Quneitra clashes, Israel threatened to attack Syrian forces, UN peacekeeping chief says UN's peacekeeping chief told a special UNSC session that Assad regime military tanks entered Golan Heights demilitarized zone during clashes at Quneitra border post, and IDF threatened to respond. Senior IDF official confirms the warning was given.


During the meeting with 15 members of the Security Council in New York, Ladsous said that the Israel Defence Forces and Syrian military were on the verge of the most direct military clash between the neighboring countries on the Golan Heights front in the past 40 years.

One of these days, it's gonna blow real bad.

PiltdownMan's picture

Not to beat a dead horse, but when The Fed has a ZIRP and the USDA is backing Martha's Vineyard mortgages, you know this is creating an epic bubble. See this guy's story.


Schmuck Raker's picture

Oh look! Some nice fellow has chosen to share a link to some real estate professor's website...AGAIN.

We are truly blessed - thank you nice fellow.

buzzsaw99's picture

there are no crowds, there is only the bernank

Frastric's picture

And a horde of algorithms...

Yancey Ward's picture

The Algorithmic Horde.......I like it!

Eric L. Prentis's picture

Tyler Durden—interesting article, “On The Wisdom Of Crowds (And Madness Of Mobs).” However, you and most of academe, especially financial economists at leading universities, are two years behind the times.


The Efficient Market Hypothesis or Theory (EMT) is scientifically proven incorrect.


Please see, Evidence on a New Stock Trading Rule that Produces Higher Returns with Lower Risk” (2011) in the International Journal of Economics and Finance and EARLY EVIDENCE ON US STOCK MARKET EFFICIENCY: “Market vs. State” Debate and Deregulation Implications,” (2012) in Economics and Finance Review.

Making minor adjustments to a flat out wrong EMT is not going to make it workable. Or saying this in another way, “Putting lipstick on a fat pig will not make it beautiful.”

MedicalQuack's picture

Modern Portfolio Theory in general and the Efficient Markets Hypothesis (EMH) are just some new buzz words fro some new models and algorithms.

Human behavior has not changed and I just about choke when I see the media making a big deal of Larry Summers being the replacment for Bernanke..who's that dumb?  Go back and watch the documentary "Inside Job" if you don't get this by all means.  Obama fooled once but running the Fed would mean someone gets fooled twice.

I'm a reformed nerd or geek or whatever one wants to call me as I don't write code anymore but I used to and when I see and read news about technology I go right for the logicl and data mechanics.  The average consumer doesn't have this option and thus I try to bring things forward as best I can to help educate the layman on why and how some of this stuff happens.  If they don't read my stuff or anyone else out there that preaches real logic, then the only thing left is irrational behavior.  We are all afraid of the unkknown and algorithms are not stable and so there's unkown creeping around all the time with rogue algorithms or math models that lie for profit with reducing risk.  Banks and insurance companies and a lot of others are just software companies that write code that controls and moves a lot of money.  I'm not that smart on that one either but rather am agreeing with a point made by an annonymous banker who said it first.


I'm beginning to put more faith these days in this PLOS ONE study that says the fear of math gives people actual physical pain and I assume those on the Street either never had this affliction or got over it a long time ago:)


So the wisdom of crowds is fear?  Is is wisdom?  Some of it could be if they know the logic and data mechanics because that's what's running the world today. 

On the other hand, irrational behavior rules too when panic sets in and sometimes it's good to draw attention but perhaps doesn't get to the root of the problem as the processes are complext and way over the head of the layman.  There's no other choice when you think about it sadly.  The media pumps it too so irrational behavior takes the front spot when in fact logic should have been first but again without a bit of a technical background on data mechanics, what other choice is there?  Again, laymen can read if they want and get educated and some do, but others will always remain irrational instead of logical.  If a few more each day entertain just a bit of logic we might see the light at the end of the hall.  I know I drive people nuts at times with logic but it is the truth with data and code as it behaves like it is written and humans don't do that.  Geeks on the other side of the coin too have a probelm understanding that side of it too.  Math models and code don't play out in the real worlds as it is "designed" all the time as things like ethics work to try to keep the world as human as possible with balance, what we need. 

Umh's picture

New buzz words? How old are you?


P.S. I thought EMH was silly when I went to school.

FreeMktFisherMN's picture

Nassim Taleb destroys sheep modern portfolio theory and EMH adherents.

Blopper's picture

This is not even a bull/mob market.

And Tyler Durden is a fear-mongering bastard.

Free Wary's picture

And that's why you read every word Tyler posts.

polo007's picture

Hey guys,

Here is a downloadable PDF version of this document:


The Wisdom of Crowds

Are markets efficient? This is a debate that has been on-going for decades. In one corner you have the proponents of the Efficient Markets Hypothesis. In the other corner you have the supporters of behavioural finance. Out of this long lasting stand-off a new paradigm is emerging called the Adaptive Markets Hypothesis which aims to reconcile the two.