Wisdom of Crowds: Definition, Theory, Examples

What Is Wisdom of Crowds?

Wisdom of crowds is the idea that large groups of people are collectively smarter than individual experts when it comes to problem-solving, decision-making, innovating, and predicting. The idea is that the viewpoint of an individual can inherently be biased, whereas taking the average knowledge of a crowd can result in eliminating the bias or noise to produce a clearer and more coherent result.

The theory is often applied to financial markets to show why markets in some instances operate efficiently and other times, inefficiently. Market participants in the crowd need to be diverse and have an incentive for markets to function efficiently.

Understanding Wisdom of Crowds

The wisdom of crowds concept was popularized by James Surowiecki in his 2004 book, The Wisdom of Crowds, which examines how large groups have made superior decisions in pop culture, psychology, biology, behavioral economics, and other fields.

The idea of wisdom of crowds can be traced back to Aristotle’s theory of collective judgment as presented in his work Politics. He used a potluck dinner as an example, explaining that a group of individuals may come together to create a more satisfying feast for the group as a whole than what one individual might provide.

Crowds aren’t always wise. In fact, some can be the opposite. Take, for instance, frenzied investors who participate in a stock market bubble like the one that occurred in the 1990s with dotcom companies.

The group, or crowd, involved in this bubble invested based on speculation that Internet startups would become profitable at some point in the future.

Many of these companies’ stock prices soared, despite the fact that they had yet to generate any revenue. Unfortunately, a good portion of the companies went under as panic ensued in the markets following mass sell orders on the stocks of some of the major tech companies.

Characteristics of a Wise Crowd

According to Surowiecki, wise crowds have several key characteristics:

1. The crowd should be able to have a diversity of opinions.
2. One person’s opinion should remain independent of those around them (and should not be influenced by anyone else).
3. Anyone taking part in the crowd should be able to make their own opinion based on their individual knowledge.
4. The crowd should be able to aggregate individual opinions into one collective decision.

A 2018 study updated the wisdom of crowds theory by suggesting that crowds within an existing group are wiser than the group itself. The researchers called their results an improvement over the existing wisdom of crowds theory.

They recorded responses to their questions privately, from individuals, and collectively, by having small groups that were subdivisions of larger ones discuss the same question before providing an answer. The researchers found that responses from the small groups, in which the question was discussed before an answer was agreed upon, were more accurate than individual responses.

Wisdom of Crowds in Financial Markets

The wisdom of crowds can also help explain what makes markets, which are a type of crowd, efficient at times and inefficient at others. If market participants are not diverse and if they lack incentives, then markets will be inefficient and an item’s price will be out of step with its value.

In a 2015 Bloomberg article, wealth manager and columnist Barry Ritholtz argued that prediction markets (for example, futures markets), unlike markets for goods and services, lack the wisdom of crowds because they do not have a large or diverse pool of participants.

He points out that prediction markets failed spectacularly in trying to guess the outcomes of events such as the Greek referendum, the Michael Jackson trial, and the 2004 Iowa primary. The individuals trying to predict the outcomes of these events were simply guessing based on public polling data and did not have any special individual or collective knowledge.

While there is merit to the idea that the many are smarter than the few, it is not always true, particularly when members of the crowd are aware of and are influenced by one another’s ideas. Consensus thinking among a group of people with poor judgment can, unsurprisingly, lead to poor group decision-making; this factor may have been one of the causes of the 2008 financial crisis.

It can also explain why democracies sometimes elect unqualified leaders. In other words, as explained by British science writer Philip Ball in a 2014 article for the BBC, it matters who is in the crowd.

Advantages and Disadvantages of Wisdom of Crowds

Wisdom of crowds allows for diversity and a broad range of thinking. This provides more color and experience in problem-solving than that of an individual, which may often be biased. It also allows for the integration of information, whereby the vast knowledge of separate individuals creates a larger knowledge pool.

One of the main criticisms of the wisdom of crowds is that humans tend to conform, leading to "groupthink," which defeats the purpose of the diversity needed in wisdom of crowds. In addition, if many individuals are aiming to reach a decision and consensus, it can lead to disagreements and in-fighting.

Examples of Wisdom of Crowds

Two examples that show how the concept works:

1. By averaging together the individual guesses of a large group about the weight of an object, the answer may be more accurate than the guesses of experts most familiar with that object.
2. The collective judgment of a diverse group can compensate for the bias of a small group. In trying to guess the outcome of a World Series game, fans may be irrationally biased toward their preferred teams, but a large group that includes plenty of non-fans and individuals who dislike both World Series teams may be able to more accurately predict the winner.

The Bottom Line

Wisdom of crowds is a theory that assumes that the knowledge of a crowd results in better decision-making, innovation, and problem-solving than that of an individual. A crowd needs to be large, diverse, and individuals within the crowd cannot be influenced by others for the theory to work. Wisdom of crowds can explain much of the efficiency and inefficiency of financial markets.