The Folly of Crowds

A popular idea that is making rounds is the concept of the wisdom of crowds: that a “diverse collection of independently-deciding individuals is likely to make certain types of decisions and predictions better than individuals or even experts.”*  To have a wise crowd, four elements are required: diversity of opinion, independence, decentralization, and aggregation.  Instead of looking at the wisdom of crowds, let’s take a look at the folly of crowds, or what happens when these four requirements are not met.

Now, before we dive in, I have to give you some context.  One of the privileges of being a financial advisor who works with Fidelity is that I get all sorts of financial research goodies delivered piping hot to my inbox.  I can’t share all of it with you (because there’s a lot), but I did get this interesting nugget of knowledge: Could consumers slow the recovery?

There’s an interesting bit where the consumer’s skill at forecasting inflation is discussed.  It’s not flattering. Here’s the relevent stretch:

Consumers have been poor forecasters of inflation. Using the University of Michigan survey of consumers, the correlation between inflation expectations for the next 12 months and actual inflation (CPI) was only 0.04 during the past 25 years. This near-zero correlation implies that consumers were just as likely to overestimate inflation as they were to underestimate inflation.” [Emphasis theirs.]

Wow.  They’re saying that consumers are bad judges of future inflation.  But we’re a crowd!  Aren’t we supposed to be wise?  Well, let’s take a look at why we fail to qualify as a wise crowd.

  1. Diversity of opinion:  I think it’s safe to say that there is a diversity of opinion available on future inflation rates.  Just in the last two months I’ve heard that there will be imminent deflation that will destroy us all and imminent hyperinflation that will destroy us all.  Either way, we’re doomed?  There have also been some more moderate opinions voiced.  So, diversity of opinion: check.
  2. Independence:  I think the argument could be made that there is not a lot of independence in how we think of future inflation rates.  While there may be a diversity of opinions available, most people get their opinion from the most convincing sounding (or loudest) white man person on TV.  Put another way, most people don’t come up with their inflation forecasts independently and based on their own research, but instead take an opinion from someone who sounds like they know what they’re talking about.  For independence: uncheck.
  3. Decentralization:  This is supposed to represent the ability of the crowd to draw on local knowledge or specialize.  While it’s hard to apply local knowledge to an abstract national economic indicator, it is possible to specialize in the study of inflation.  Of course, there aren’t that many specialists in the population of consumers, so I suspect they don’t have a significant effect on the average forecast.  For decentralization: half-check at best.
  4. Aggregation:  The method of turning private judgements into a collective decision.  The University of Michigan data set and the applicable analysts did this for us.  So let’s put down a check for aggregation.

So, in summary, one of the strongest reasons I think the wisdom of crowds idea doesn’t apply to forecasting inflation rates is that there is a tremendous lack of independent opinion on future rates.  I would love to hear your opinion on the subject though, so please leave a note in the comments and let me know what you think.

* Wikipedia

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