Wise Crowds Tell No Lies

by on November 18, 2013 at 3:23 pm in Economics | Permalink

One of the benefits of tapping the wisdom of the crowds is that the market doesn’t lie*.  Not even white lies, as Lars Christensen found to his chagrin when he recently gave a talk to investment advisors in the Danske Bank group:

As I was about to start my presentation somebody said “The audience have been kind of quiet today”. I thought that was a challenge so I immediately jumped on top of a table. That woke up the crowd.

I ask the audience to guess my weight. They all wrote their guesses on a piece of paper. All the guesses was collected and an average guess – the “consensus forecast” – was calculated, while I continued my presentation.

I started my presentation and I naturally started telling why all of my forecasts would be useless – or at least that they should not expect that I would be able to beat the market. I of course wanted to demonstrate exactly that with my little stunt. It was a matter of demonstrating the wisdom of the crowds – or a simple party-version of the Efficient Market Hypothesis.

I am certainly not weighing myself on a daily basis so I was“guestimating” my own weight then I told the audience that my weight is 81 kilograms (fully dressed). I usually think of my own weight as being just below 80 kg, but I was trying to correct it for the fact I was fully dressed – and I added a bit extra because my wife has been teasing me that I gained weight recently.

As always I was completely confident that the “survey” result would come in close to the “right” number. So I was bit surprised when the  ”consensus forecast” for my weight came in at 84.6 kg

It was close enough for me to claim that the “market” – or the crowd – was good at “forecasting”, but I must say that I thought the “verdict” was wrong – nearly 85 kg. That is fat. I am not fat…or am I?

So once I came back home I immediately jumped on the scale – for once I hoped to show that the Efficient Market Hypothesis was wrong. But the verdict was even more cruel. 84 kg!

So the “consensus forecast” was only half a kilo wrong and way better than my own guestimate. So not only am I fat, but I was also beaten by the “market” in guessing my own weight.

* The market doesn’t lie doesn’t mean the market is always correct. A lie is an intentional falsehood. Market manipulation would be analogous to an intentional lie so it’s not impossible for markets to lie only difficult much of the time.

1 Matt November 18, 2013 at 3:34 pm

nearly 85 kg. That is fat

Only for a short man.

2 Lars Christensen November 18, 2013 at 3:53 pm

Add to that I have skinny arms!

3 john personna November 18, 2013 at 4:31 pm

Have them “trade” your July 2014 weight 😉

4 Willitts November 18, 2013 at 7:58 pm

That can be manipulated. 🙂

The futures weight will likely quickly converge to the July 2014 spot weight, but the subject will likely make a lot of money betting on his own weight gain or loss. That fact alone might make the market illiquid. Who thinks they can outguess the weighee or persons close to him?

Semi-strong EMH. 🙂

5 mw November 18, 2013 at 3:43 pm

I’ve gotta say, these market thingies do sound pretty amazing…I’m wondering, do you think there’s a way we could apply them to our financial sector; or telecoms/ISPs; or hospitals; or federal contractors; or Apple?

6 Z November 18, 2013 at 4:29 pm

Let’s not get carried away. Guessing weight or setting prices is one thing. Running a sophisticated, post-reality economy is another matter entirely.

7 Michael November 18, 2013 at 5:17 pm

Post-reality! Hello, tech support, can you help? the cultural studies department is leaking!

8 Silas Barta November 18, 2013 at 3:54 pm

I did the experiment myself, got similar results. See the post on my blog about it. (I made sure to hide my actual weight though, so only % differences are show.)

9 Z November 18, 2013 at 4:36 pm

I’m not so sure this is much of a proof. Looking at your pic, it is possible to eliminate all but a narrow range of choices. Most people will guess your weight within 10% one way or the other. I serious doubt anyone guessed 500 pounds or ten pounds. Narrow the range of plausible choices and the crowd gets wiser, so to speak.

10 Silas Barta November 18, 2013 at 5:25 pm

But note — the individual guesses tended to be much farther off than the average of the guess. 3.6% vs 6.3% (or 10% if you average the error of the guesses).

11 Willitts November 18, 2013 at 8:01 pm

How did the non-numerical guess do? 🙂

12 ummm November 18, 2013 at 3:57 pm

that is why Shiller is wrong to think that bubbles are predictable, and yet he’s regarded as an ‘expert’ in that area.
its impossible to predict bubbles or achieve excess returns by betting against bubbles with any consistency. The majority of times you will lose money shorting what you think are bubbles, but have an underlying fundamental trend that you are oblivious to, or ignoring. And even if you are right in the ogn term you can still get margin-called out and forced to buy the shares back at a total loss.
For example, pundits though snapchat was a bubble at $100 million. Now ts worth 4bn. Twitter was supposed to be a bubble in 2008; now its worth $24 billion. Many examples of this.

13 john personna November 18, 2013 at 4:25 pm

Well, I missed where this was a “market” above. A crowd of disinterested parties may indeed guess well. Unfortunately, markets have several factors which differentiate themselves from a one-time guess. In an iterative play, where interested parties to squeeze past one another, again and again, all the documented anomalies occur.

This kind of Shiller criticism is silly on several levels, but not least because it is based on a lot of cherry picking. Shiller wins because the full history of markets includes manias and panics. And yes, sometimes they have been widely called.

14 Brian Donohue November 18, 2013 at 4:32 pm

Yes. Shiller’s foresight is so extraordinary that he called the housing bubble all the way back in 1996.

15 john personna November 18, 2013 at 4:36 pm

So … what’s the argument here … if Shiller cannot personally call all bubbles, there are no bubbles?

It strikes me that the real answer is that bubbles are common but prediction is hard. Unfortunately we only get straw man arguments in response to that, and claims (without supporting logic) that anything common must be predictable. No.

16 john personna November 18, 2013 at 4:37 pm

But note that Shiller’s public prediction record is actually better than most, especially the “I never see a bubble” types.

17 Willitts November 18, 2013 at 7:28 pm

Since 1996 is exactly when the bubble began, I’d say it is very extraordinary.

Bubbles begin when prices depart from fundamentals, not when they are realized in a correction. Take a look at home prices, and it is pretty obvious that something drastic changed in 1996. That something was our national housing policy.

18 Brian Donohue November 19, 2013 at 10:51 am

So… is the stock market a ‘bubble’ today? How about 2007? How about 2009- a negative bubble?

19 john personna November 19, 2013 at 11:26 am

Interestingly, the Shiller PE said don’t buy in 2007, and suggested a buy in 2009. Buying in 2007 would have been painful. Buying in 2009, when the Shiller PE dropped to 15, would have been pretty amazing.

20 Justin Short November 18, 2013 at 4:51 pm

Well, we are building a hedge fund powered by the crowds! The hypothesis is that day trading is a talent (pattern matching, prediction of human psychology), and this is borne out by our own preliminary data and by a couple of recent studies. The key is finding and incentivising the players to play well – which we do by offering the app for free but paying cash prizes. We believe that we can find and/or train talent in developing countries who are much cheaper than those in developed. And along the way we’ll just have to disprove EMH and reduce global income and opportunity inequality.

The site is nous.net for anyone interested in trying it out.

21 Silas Barta November 18, 2013 at 5:32 pm

Whoa!!! Brilliant idea! How about paying monetary rewards to those who predict market moves before they happen? And … and how about if you reward them in proportion to the magnitude of the mis-pricings they see? And what if you ran big exchanges based on real-world commodities and equities?

You’ll have reinvented what financial markets already do!

22 Justin Short November 18, 2013 at 6:48 pm

The intersection of “people with the ability to trade” with “people with the means to trade” is a small one. We help expand it.

23 Brian Donohue November 18, 2013 at 6:59 pm

Disproving the EMH, or improving it?

24 Willitts November 18, 2013 at 7:35 pm

There is such a thing as incomplete markets.

The market can stay irrational longer than you can stay solvent. This is consistent with EMH to the extent that the solution given the market failure is second best. Call it a Quasi-Efficient Market Hypothesis. The market isn’t necessarily efficient, but no one can benefit from the inefficiency. As we have seen, though, the deviations from efficient pricing can become quite large in the presence of market distorting factors such as subsidies, tax incentives, levered financing, financial innovation, global capital imbalances, artificially low interest rates, regulatory arbitrage, etc.

25 john personna November 19, 2013 at 12:02 pm

There is a lot of truth in the line “The market can stay irrational longer than you can stay solvent.” It’s amazing really the years we had in the wilderness, when people tried to believe other things. We are back though, I think.

26 Ross November 18, 2013 at 5:06 pm

Nice example about the wisdom of the crowds. And this was a very low-stakes guess. I would imagine that the crowd’s guess would be even more accurate if their was an economic incentive for the guessers to guess accurately. This reminds me of the importance of prediction markets.

27 Willitts November 18, 2013 at 7:40 pm

I wonder how close the average guess of the number of jelly beans in a jar would get. Like weight, the beans and jar are identically observable to all guessers, and the mathematics of average bean size to container volume is fairly straightforward. The amount of unfilled space should follow a well behaved distribution. Obviously, the vast majority of guessers won’t attempt a mathematical solution. Im wondering if the wisdom of the crowd makes this an as if proposition.

28 Metungdh November 24, 2013 at 5:49 pm

Results of this comp would be interesting, Willitts: http://www.thejellybeanjar.com . Enjoy!

29 Curt F. November 18, 2013 at 8:15 pm

But would the crowd’s average guess be more accurate or less accurate if they were told not to guess Lars’s weight, but rather to guess the average of the crowd’s guess of Lars’s weight?

30 carlospln November 18, 2013 at 11:00 pm

Its a direct lift from Chapter One of the Surowiecki book:

http://www.amazon.com/The-Wisdom-Crowds-James-Surowiecki/dp/0385721706

This is news? What’s the point of this post? The book is almost ten years old.

31 Marie November 18, 2013 at 5:14 pm

Who cares about the economics implications? That’s just overall awesome all by itself.

32 Mike Huben November 18, 2013 at 5:49 pm

Why, the next thing you know they might apply this new methodology to figure out who should fill positions in government! Think of how government might be improved if only crowds were to choose the leaders! What ever could we call such a methodology?

33 Willitts November 18, 2013 at 7:42 pm

And let’s give the participants only two choices: too fat or too thin.

34 derek November 19, 2013 at 12:17 am

And poof, you replicate the Toronto political landscape.

35 8 November 18, 2013 at 11:57 pm

It is true that markets don’t lie. They reflect the underlying beliefs of the participants. But the herd is often wrong. At the peak of a bubble, the crowd is very large and filled with non-experts. If you trade using sentiment and mood indicators, the markets hardest to trade (and not worth trading) are those with very little public interest because those markets are filled with experts. It is the mass markets filled with average people that are the easiest to trade on sentiment.

People pay more for financial assets when the prices rise, the exact opposite of how they behave when shopping for groceries or TVs.

36 derek November 19, 2013 at 12:27 am

A more interesting test would have the participants divided in thirds, one third gets a description of you from your current girl friend, the second from your ex-wife, the third from your mother. I wonder if the thesis would hold?

37 Rob November 19, 2013 at 10:07 am

Markets don’t lie? The LIBOR market, the auction rate securities market, the commodities markets, the foreign exchange markets – to name a few – have all been manipulated in the last year. Those are the ones off the top of my head…there are likely more. Markets don’t lie in a world where the justice system exists for financial firms … a world that doesn’t exist in America right now.

38 Nate November 19, 2013 at 10:40 am

I don’t understand how a market cannot lie. Could someone shed light on this. There are tons of companies trading over their value. To me that is a lie. A company that is reporting profits or engaged in other fraud like behaviors seem like lies to me. How is Enron or Long Term Capital not a lie. Eventually things come out and surface but I am certain for every blip detected there are 3 to 4 more that go undetected. Deception is abundant in any natural system. Why would a market be different? My logic may be flawed but a market that does not lie would be flat and exist at a constant equilibrium meaning no gains and no loses.

39 john personna November 19, 2013 at 1:03 pm

It is a semantic argument. As long as price is just a record of an exchange, it is not a lie. Of course, something like high transaction order-and-cancel might be a lie happening many thousands of times a day (hour?).

40 Nate November 19, 2013 at 2:18 pm

I see. For me, I am of the opinion that competition requires some form of deception in order to make a gain. For instance in the author’s experiment replace him with a pregnant woman that does not show, or someone with a tumor, or someone who drank and ate a heavily salted meal the day before. Their weight would not be what it seems. Let’s pretend the author tipped scale at 84 as he reported. What if he the night before had forgotten that he had wine and ate pork belly. He could easily weigh 5 lbs more in a morning due to water retention. Now he accepts that data honestly and verifies the audiences guess. However he in essence has mislead them to believing they guessed properly simply by omission. Would his omission not classify as a lie?

41 g November 19, 2013 at 12:31 pm

Ask them to guess your blood pressure or cholesterol level.

42 The Anti-Gnostic November 19, 2013 at 2:05 pm

Tyler has to put in that asterisk, because markets for white neighbors, CMO’s and sovereign debt seem to require constant intervention.

43 Daniel Earwicker November 19, 2013 at 7:26 pm

Presumably well known to readers of this blog, but relevant nonetheless:

http://www.johnkay.com/2012/07/25/the-parable-of-the-ox

44 Karl Pinnp November 20, 2013 at 5:22 pm

What about LIBOR, what about commodity warehousing, what about insurance companies, what about the fact the western government’s felt it was necessary to constrain Microsoft, what about high frequency trading, what about price fixing in the options market? There are large sectors of the economy that are constantly being manipulated. Has Cargill or Archer Daniels Midland ever paid a fine for price fixing corn or soy?

What about the fact that everyone realizes that financial asset prices are being manipulated and socialized by global central banks?

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