Since I try to make money by taking advantage of the stupidity of large groups, I nearly made the mistake of disregarding Michael Mauboussin's recent essay Explaining the Wisdom of Crowds: Applying the Logic of Diversity. But I did read it, if only to delight in proving it wrong in my own mind. And, to my surprise, I found it valuable.

Mauboussin correctly assumes three conditions are required for crowds to make superior judgments: diversity, incentive and aggregation.

The diversity assumption keys on the expectation that the ignorant will cancel out and the knowing will prevail. This reminds me of the old saying that a committee could have come up with the theory of relativity, but Einstein would have had to be on the committee.

The incentive assumption keys on the expectation that the smarter guessers will be drawn off the sidelines. This has me wondering about the electoral process.

The aggregation assumption keys on the expectation that there is an efficient means for combining the opinions of the crowd, in a fair and balanced manner. That seems obvious enough, but unlikely. I am reminded of Keynes characterization of the market as traders attempting to guess what others will guess that others will guess.

So, it seems I should keep an eye out for investments priced by a narrowly focused group, where there is little incentive for broad based participation and where the method of combining the opinions is broken or subject to substantial distortion. An example would be an inactive investment (no incentive) priced according to a commonly held (mis)belief (group think) in a poorly communicated market (little aggregation of opinions). That works for me.


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