Credit: Patrick Regout

Relying on the wisdom of crowds can be dangerous

EVERYTHING YOU KNOW ABOUT BUSINESS IS WRONG: Here's why it's not always best to follow the herd in business.

by Alastair Dryburgh
Last Updated: 14 Jun 2016

I'm seeing a lot of advertising for a 'social trading network', which allows you to 'trade with confidence' by 'automatically copying the leading traders in our community'. To my mind this sounds like an algorithm for losing money. You don't win in trading by following the herd - you either need to be leading it, or proceeding in another direction entirely.

Yet the idea of gaining confidence by doing what everyone else is doing is deeply seductive, because it's programmed into our psychology. It's called 'social proof' and is brilliantly expounded by Robert Cialdini in his book Influence. (Many of whose case studies are of con artists and sleazy salesmen. Just saying ...)

But you can't dismiss social proof (or its better-known variant the wisdom of crowds) completely. Relying on social proof can be either valuable, or highly dangerous. It depends on the context.

The crucial point is that there are two types of statement. One describes reality and one creates it. Consider, for example, an investment manager. If she says 'company X will make £300m of profit next year', this is purely descriptive. It can be right or wrong. If on the other hand the same manager says 'shares in company X are good value at £10', this statement creates reality, because she (and others like her) will then go and buy those shares at £10, because they are good value.

In the first case, the descriptive earnings forecast, the wisdom of the crowds can be useful. The consensus of several analysts will probably be more accurate than any one of them alone. In the second case, however, it will not - it will create an unstable pattern of self-reinforcing decisions. A thinks it is worth £10, so lots of people buy, so B thinks it is worth £11, then more people buy and C says £12 ... This is how bubbles are created.

So next time you feel the urge to follow the wisdom of crowds, apply the test. Does the view of the crowd affect the reality? If it does, you know it's time to leave the herd and do your own thing.

Alastair Dryburgh is chief contrarian at Akenhurst Consultants. Visit alastairdryburgh.com

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