Categories
the psychology of successful trading

The “Wisdom of Crowds:” Very Risky in Financial Markets

Introduction

The “wisdom of crowds” is the idea that people are generally right so we should generally do what they do. Unfortunately, while they are generally right, they are usually wrong in financial markets. So there is no wisdom of crowds to be found there. That doesn’t stop people relying on it. Here I will suggest you should go your own way. It will be very expensive to follow the crowd.

We all tend to do what everyone else does, even when we can see that everyone else is wrong.  In financial markets, this can lead to bubbles and herd behaviour.  It is important to be aware of this tendency within our psychology, so you can at appropriate times avoid joining in the bubbles.  It is important to do this because you will lose a lot of money if you participate or, once in, fail to exit before everyone else does.

In this post, I will briefly outline the relevant psychology. So you can both look for the effects in your own thinking and expect those same effects in other market participants.  This will improve your trading.  I discuss this bias and many others in a financial markets context in my new book The Psychology of Successful Trading.

Photo by Mike Chai on Pexels.com

Conformity Bias

Conformity Bias is also known in the literature as the Asch Effect, after the pioneer experimenter.  Asch obtained really surprising results, which will show you how strong this effect is.  He had a naive member of the public sit in a room in front of a blackboard with four other people.  The member of the public thought that the other four people were also naive members of the public. In reality they were actors who were going to behave in a specific way suggested by Asch.

https://www.simplypsychology.org/asch-conformity.html

The experimenter draws a line of a certain length on the left side blackboard.  The experimenter also draws other reference lines of different lengths on the right hand side.  One of them was clearly the same length as the reference line. All of the rest were clearly much shorter or much longer.  Asch then had the people say which of the test lines on the right was the same length as the reference line.

If the naive member of the public went last and heard all of the actors give a wrong answer, he tended to go along with them. That was true even though the answer was obviously and clearly wrong.  Amazingly, Asch found that most people gave an obviously wrong answer some of the time. Some people gave wrong answers most of the time.

This is how strong Conformity Bias is: it works even when the answer is obvious.  Imagine how much more dangerous it is in financial markets. The answers are much less clear cut and much ambiguous and conflicting data must be weighed.

Bubbles are Caused by the Wisdom of Crowds

I think this is one factor behind a lot of famous bubbles in financial history. Right now, it looks to me as though the cryptocurrencies, most notably Bitcoin, are exhibiting bubble characteristics.  One sign of this is the enthusiasm of a particular football manager, one noted for his lack of financial acumen, for Ethereum.  I do not say this is a scam; I merely suggest that one should look to more fundamental underpinnings for value than “everyone likes it and it has gone up a lot.”

Avoid Conformity Bias and trade better by trading the other way when you see it happening.

The wisdom of crowds might get you across the road but it will kill you in trading.

See Also:

What Is “Theory Of Mind?”

The Illusory Truth Effect And Financial Markets

If You Like Gin And Marmite, You Are Probably A Better Trader

The Late Evaluation Effect And Financial Markets