TripleScreenMethod.com
Current Monthly Trading Article
(appeared in August '04 issue of CANSLIM.net News)
The Crowd’s Opinion is
Better than the Expert's
As counterintuitive as it sounds, the crowd is often more accurate in its analysis than the individual, even if that individual is an expert. Surowiecki, in his remarkable little book, The Wisdom of Crowds, puts it this way: "...ask a hundred people to answer a question or solve a problem, and the average answer will be at least as good as the answer of the smartest member. With most things, average is mediocrity. With decision making, it's often excellence. You could say it's as if we've been programmed to be collectively smart."
Experts frequently get it wrong. Examples litter history:
Erasmus Wilson,
professor at Oxford University said: "When the Paris exhibition closes,
electric light will close with it and no more will be heard of it;" Captain
Edward J Smith of the Titanic: "I cannot imagine any condition that would
cause this ship to founder;”
A diverse group of
people possessing various degrees of knowledge and insight and acting
independently in their own interest, outperforms experts.
Whether guessing the number
of jelly beans in a jar, the weight of an ox, predicting the outcome of the
presidential election, or determining the position—within 200 yards--of a
downed submarine (1968 Scorpion), the crowd's estimate, i.e., its
collective view, has proven to be far more accurate than any expert’s
opinion (examples cited in The Wisdom of Crowds).
A good example is what happened following the Challenger disaster. Within minutes, investors dumped the stocks of its four major contractors: Martin Marietta (manufactured the external fuel tank), Rockwell International (built shuttle and its main engines), Lockheed (managed ground support), and Morton Thiokol (built solid-fuel booster rocket). Twenty-one minutes after the explosion, before anyone had a clue as to what had happened, the investing crowd had spoken: Martin Marietta was down 3%, Rockwell International 6%, Lockheed 5%, and Morton Thiokol had so many people trying to sell and so few willing to buy that a trading halt was called (by the end of the day it was down 12% while the price for the other three had begun recovering). The crowd almost immediately labeled Morton Thiokol responsible, even though that day there had been no public comments singling out Thiokol. Six months later a Presidential Commission revealed that O-ring seals on the booster rockets made by Thiokol were indeed responsible.
In another example, Surowiecki illustrates the intelligence in the crowd's opinion by citing findings from the television quiz show "Who Wants to Be a Millionaire?" Participants on this show, if you remember, could choose help in answering specific questions: either to phone a friend or ask the audience. The friend had presumably been selected on the basis of his or her superior general knowledge, while the audience consisted of a group of people with nothing better to do that afternoon than wander into a TV studio. Over the life of the show, the friend (the so-called expert) came up with the right answer 65% of the time, while the crowd had an amazing 91% success rate. So how can we use the crowd's opinion to our advantage?
Several groups have developed futures markets to predict from the crowd’s opinion: presidential elections (Iowa Electronic Markets), new drugs (Eli Lilly), new technologies--and the weekly close of the Nasdaq--(Technology Review). The Defense Department even had the foresight to suggest a market-based approach to forecast the likelihood of terrorist events (Policy Analysis Market) before a squeamish Congress nixed the idea (Carl Hulse, The New York Times).
In the stock market, the price of a stock is set by people representing all sorts of levels of information, intelligence, and resulting expectations: traders betting a stock’s price direction over the next few minutes to weeks, long-term investors expecting the value of their shares to rise and short-sellers betting the price of a stock will fall. Through their collective buying and selling, the market efficiently prices the value of a company's stock. This crowd's response to fear and greed manifests itself in predictable chart patterns, e.g., the multi-day pullback after a period of steady rise followed by its reversal at specific levels of symmetry (often common Fibonacci levels). These are crowd responses that have played out the same way for the past 100 years.
Fibonacci ratios likely measure the balance between human fear and greed, i.e., as price falls, fear dominates, and sellers rule, but a point is reached where greed enters, an opportunity is perceived, buyers again rule, and price climbs. I recently poled a group of 121 traders for their preference as to where they would expect the reversal of a pullback to begin. They were shown a picture of rising daily bars (white bars on Chart 1 without the percentages) and then asked to choose a point at which they thought this pullback would most likely reverse: 1.7% chose a 12% reversal, 0% a 19% reversal, 5% a 27% reversal, 77.4% either the 38, 50, or 62% most common Fibonacci reversals, 9.2% a 75% reversal, and 5% a 91% reversal. It’s natural for the crowd to expect a reversal at these three standard Fibonacci levels. That’s where they want to step in to buy again! That's where they perceive the stock is a bargain again! It's a natural symmetry expected by the crowd.
Sidebar
I would like to use the
power of you, the knowledgeable crowd, to predict the short-term market
action. Specifically, I want to ask whether you think the S&P 500 will be
up or down the following day. I want the information by ten pm. For my
part, I will compile the results and post them here. According to
Surowiecki's theory, even a few hundred people, acting independently with
their own informational sources and biases and level of expertise, can more
accurately assess tomorrow's price action than a few selected
professionals. If that's true, then we might be able to make the following
qualification: There is
c%
probability that the market will be up tomorrow. And with the support of
that knowledge, one could then make the decision to short, stay out of, or
go long the market. Interested in participating and receiving in turn the
compiled results? Send an email to
rmiller@triplescreenmethod.com.