Wisdom of Crowds
Why a thousand average people are often smarter than one genius.
#Plain-English Definition
The Wisdom of Crowds is the theory that the aggregated opinion of a diverse group of independent individuals is often more accurate than the opinion of a single expert.
The classic example involves guessing the weight of an ox at a county fair. While most individuals guessed wrong (some too high, some too low), the average of all the guesses was almost exactly correct.
#Conditions for Success
For a crowd to be wise, four conditions must usually be met (according to James Surowiecki):
- Diversity of Opinion: Each person should have private information even if it's just an eccentric interpretation of the known facts.
- Independence: People's opinions aren't determined by the opinions of those around them.
- Decentralization: People are able to specialize and draw on local knowledge.
- Aggregation: Some mechanism exists for turning private judgments into a collective decision (e.g., a Prediction Market).
#Why It Matters
Prediction markets are the ultimate "Wisdom of Crowds" machine. They provide the Aggregation mechanism (price) and incentivize Diversity and Independence (you only make money if you are right, regardless of what others think).
When you see a prediction market giving a candidate a 20% chance of winning, that is the "Wisdom of the Crowd" speaking. History suggests this number is often more reliable than a pundit on TV.
#Key Takeaways
- Groups can filter out individual noise and bias to find the signal.
- Prediction markets monetize this phenomenon.
- The crowd fails when diversity or independence is lost (e.g., during a panic or a bubble).