The Foolishness of Crowds

May 24, 2012

There’s an excellent article in the April 9th, 2011 edition of The Economist under the byline ‘The Foolishness of Crowds’. In many instances it’s been shown that the judgment of a group (or crowd) is often superior to that of the most skilled individuals within the group.

 

This was the thesis of an excellent book called ‘The Wisdom of Crowds’.

 

In an effort to test the investment success of the crowd, The Economist harvested fund flows and performance statistics for all US mutual funds. After combing through the data, they found that the crowd was more foolish than wise.

The most popular funds, as measured by investor fund flows, had recently outperformed the sector return by more than 2 percentage points.

 

Unsurprisingly, to students of our investment methodologies, in the subsequent year these funds lagged their sector averages by almost 3 percentage points. The crowd consistently picked the wrong funds.

 

Why does the wisdom of crowds fail so spectacularly and consistently when applied to investing decisions? Research has found that the wisdom of crowds is only valid when forecasts are truly independent. When investors know what others are thinking, the views of others lead the investor in error.

 

Countless studies show that individuals are hard-wired to follow the herd. How does one protect against this tendency and possibly even benefit? By adopting a disciplined approach, with a bias for out-of-favor holdings, and input from an advisor who can act to prevent bad decisions.

 

I often describe my role as ‘Big Mistake Insurance’. By stepping-in when investors want to act on their herd-instinct, I save them from expensive mistakes. This is just one valued role as your Chief Financial Officer.

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