Informed decisions don’t always lead to good outcomes. Tap into collective intelligence to improve the quality of your investment decisions.
The core skill of an equity analyst is the ability to analyse and value a stock to determine its investment prospects. However, making judgments based on insights gained through the analysis and valuation, and the final decision-making, is equally prominent and an indispensable skill for successful investing.
Decision-making involves collecting data, processing the data, and making informed judgments. In the stock market, the crucial decisions are whether to buy or sell a stock or do nothing. ‘Doing nothing’ is also a decision: whether to hold your stock or stay in cash has a strong bearing on your portfolio performance. Anyway, all our investment decisions have a single purpose: to achieve superior investment returns consistently, with the least possible risk.
When Individual Intelligence Under Deliver
In the stock market, stock prices change due to the collective impact of several investors acting out their individual investment decisions. When most investors are pessimistic, they sell stocks, causing prices to fall; conversely, when most are optimistic, they buy stocks, causing prices to rise. However, it is wrong to assume that all investors make rational and logical decisions every time. Some might be making highly informed decisions, while others are making poorly informed decisions, and some others are making purely impulsive decisions.
Typically, we believe that highly informed decision-makers will have better decision outcomes and purely impulsive decision-makers will have the worst decision outcomes. But unfortunately, the truth is much farther than we believe. We can find many instances of highly informed decisions resulting in bad outcomes, and similarly, many instances of purely impulsive decisions leading to good outcomes. It may seem ridiculous, but I have witnessed several such instances from my experience in markets.
This could be discouraging because if informed decisions can’t provide better results, then what can? We may try to find comfort by attributing the ‘impulsive decision-good outcome’ combo to ‘being lucky’, and the ‘highly informed decision-bad outcome’ combo to ‘being unlucky.’ However, we can’t be lucky (or unlucky) most of the time. Therefore, when we measure the performance of a series of highly informed decisions with that of a series of impulsive decisions, we expect the former to have a large share of good outcomes, while the latter to have many bad outcomes. There is enough evidence to support the latter argument – a series of impulsive decisions will have many bad outcomes. However, there is scant evidence to prove the former argument – a series of highly informed decisions will have a large share of good outcomes. The bottom line is that ‘highly informed decisions’ are not a guaranteed path to ‘good outcomes.’ A series of highly informed decisions shall also lead to many bad outcomes.
Why does it happen so?
Hidden Information and Biases
One reason could be that, even though we are making ‘highly informed’ decisions, they still aren’t ‘fully informed‘ decisions. How much informed we might be, there may yet be more information about the situation that is unknown to us. To our disadvantage, that hidden information might be the one having the strongest bearing on the decision outcome. This reason aptly applies to the stock market because a large part of a stock’s performance depends on what happens in the future, which is uncertain, unpredictable, and largely unknown.
Another reason is biases. This is a processing error. Despite possessing sufficient information to make an optimal decision, we process the information in a biased way. One can become biased for several reasons, including ‘unrealistic expectations’. ‘Unrealistic expectations’ crop up in several ways. A stock might have doubled or tripled in a year, and we desire the stock to repeat the feat in the next year, too, even though repeating such a feat is very unlikely now. Or else, a stock we hold has recently experienced a significant decline. Still, we are unwilling to accept the loss and mistake, expecting (unrealistically) the stock to recoup our losses sooner or later. In such instances, we process information selectively to conform to our unrealistic expectations.
These are individual investment decisions made to achieve superior returns consistently. However, despite our good intentions and no matter how constructive our decision-making process might be, errors do occur that diminish the quality of our decision outcome.
So, what can we do about it?
Individual Vs Collective
Decision-making is a daunting task, especially when it concerns the future, as it is in the stock market. Perhaps, anyone would find the above discussion of experiencing bad outcomes despite making well-informed decisions demoralising. But you don’t have to be. There are ways to improve the quality of your decision outcome without tampering with your investment decision-making process. You can achieve it by tapping into the collective intelligence.
You are executing your individual investment decision when you decide to buy or sell a stock: your intelligence is at work here. In the stock market, many individual investors, just like you, come together to execute their respective individual intelligence. The consequent stock price movement reflects the aggregation of all these separate bits of intelligence, and this aggregated intelligence is the collective intelligence. Literally, stock prices – the price level and its changes – reflect the collective intelligence.
Limitation of Expertise
In any field – whether investing, medicine, or politics – our natural tendency is to find the best expert and seek his advice. It is a strongly-held popular belief that there are some exceptional individuals with superior skills – they are best at what they do; we seek them, follow them, and in some extreme cases, we deify them. The average is marginalised because they are considered mediocre. Average is dull, shun it – is the widespread mentality. But this is a fallacy. The value of expertise is overrated.
This doesn’t mean that individual expertise and intelligence are irrelevant; they matter, but only to a certain extent, and they alone aren’t enough for better judgments. One reason is that expertise is narrow. With effort, you can be good at anything, but not at everything. A single person can gain expertise only over a narrow subject. However, it is implausible for a single person to gain expertise in a broad subject like decision-making. What is required for effective decision-making is that the professional analyst should employ his expertise. Still, the output of his expertise (investment advice or insight) should be aggregated with the outputs of other experts. Decisions based on the aggregated output (the collective intelligence) are more reliable. The larger the group, the more reliable the decision.
The Crowd – Smart or Dumb?
There are extensive studies into the decision-making skill of a person and a crowd (group of persons) that show that the crowd’s decision (collective intelligence) is far superior and more accurate than individual decisions (individual intelligence). You should read the highly instructive 2004 book “The Wisdom of Crowds” by James Surowiecki if you wish to know more about how collective intelligence outsmarts individual intelligence consistently. This blog post itself is my reflection on the intriguing ideas discussed in the book.
The central theme of the book is that the crowd is consistently smarter than each individual forming it. Hence, we could be better decision-makers by tapping into the wisdom of the crowd – the collective intelligence. The fact that makes the theme so intriguing is that it goes against our long-standing understanding of crowd psychology. Previously, collective intelligence was considered impulsive and inferior to the individual intelligence of each person forming the crowd.
Popular books like “The Crowd: A Study of the Popular Mind’ by Gustav Le Bon, and “Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay discussed and popularized the concept – that the crowd lacks intelligence. Le Bon said so in his book about crowd behaviour – “impulsiveness, irritability, incapacity to reason, the absence of judgement of the critical spirit, the exaggeration of sentiments, and others…” However, the new findings – that collective intelligence is consistently smarter than individual intelligence – don’t prove that Le Bon and Mackay were wrong. In a sense, they were right, too. You might find this preposterous because how could a group of people be both smart and dumb at the same time? The truth is – they can’t be.
James Surowiecki, in his book ‘The Wisdom of Crowds’, never asserts that all crowds possess superior intelligence. The superiority is conditional. He postulates that a group (or crowd) is more intelligent than each of the individuals forming the group (or crowd) only when it satisfies three conditions: diversity, independence, and decentralisation. When a group satisfies all three conditions, the aggregation of individual intelligence of each person forming the group will provide us with a superior collective intelligence. Conversely, if the crowd lacks any or all three conditions, they might act or behave stupidly, as Le Bon and Mackay suggested.
The Three Conditions
Diversity is the first condition that makes a group smarter than most of the individuals forming the group. The members of a diverse group bring different kinds of information, styles, goals, and perspectives into the group. In such groups, errors and biases of one member get cancelled out by information from other members. For effective functioning, groups should encourage dissent; they should make people feel comfortable in expressing their perspectives. Meanwhile, cohesiveness, homogeneity, groupthink, and conformity should be discouraged as they stand in the way of a diverse group.
The second condition that makes a group smart is independence. Every member brings their own set of private information – facts, analysis, interpretation, intuition – into the group. If the group is diverse, the private information each member brings will also be diverse. The group becomes smart only if each member acts independently, guided by their private information. However, the said independence is hard to come by because of the way our society is designed.
We humans are social animals. One person influencing another is an inescapable way of human life. Learning is primarily a social process for us: we learn from others. We imitate others when we don’t know how to act or behave in a particular situation. However, this mutual influence diminishes a group’s independence – the more we are influenced by others, the more we are dependent on others for our information.
Usually, people think that other people’s behaviour is based on informed choices. So, it feels rational for them to imitate or follow others and ignore their private information. When most people start thinking this way, the group behaviour will be based on very few people’s private information. This diminishes the group’s independence and makes it less effective. Information is not concentrated in one or two people but is scattered among several. For the group to be smart, its members should act independently, steered by their private information. This can be achieved if its members pay more attention to their private information and less attention to others.
Decentralisation is the third and final condition for a group to be smarter than the most intelligent person within the group. It is a way in which the group is organised, such that the decision-making power does not reside with a single central authority, but is spread among several individuals. These individuals are those closer to the problem, and hence, better informed, and likely to find the best solution. These individuals also bring local, specific knowledge to the problem. In a decentralised group, even if the individuals on whom the decision power resides are not experts, the aggregation of their judgments will provide us with a superior judgment.
Decentralised groups have one weakness. For it to work, the information from different decision centres should be disseminated, shared, and aggregated within the group. If a group lacks such a mechanism, decentralisation will not work to its benefit.
Afterword
It is implausible for a single person to make sound judgments consistently… despite having superior expertise… because decision-making is a subject with broad contours… and thus, incapable of mastery by a single person.
However, we can significantly improve the quality of our judgments if we have the open-mindedness to collate them with those of others. Substantive studies show that such aggregation of individual judgments results in a collective judgment that is far superior to any of the personal judgments. But… for the collective to be smarter… it needs to satisfy three conditions – diversity, independence, and decentralisation.
How does this apply to us – the equity investor? We, as equity investors, should employ our analytical skills on the information available to us, independently. Additionally, we should be willing to tap into other people’s judgments. The best way to do that is by reading the market price changes, because the stock market is the quintessential collective intelligence at work – a diverse group of people acting in self-interest.
However, there are specific periods… when markets fail to be… a reliable source of better judgment. It happens… when the market fails to satisfy any of the three conditions… that make a collective smart. It is during these periods… we have episodes of manias, panics, and market crashes. Hence, as a precondition… before relying on the market’s judgment… make sure there is no breakdown in… its diversity, independence, and decentralisation.
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