Diversity prediction theorem

03Apr07

Michael Mauboussin at Legg Mason Capital Management has another research piece up in his semi-regular “Mauboussin on Strategy (.pdf)” series. This time inspired by a new book by Scott Page entitled The Difference, Mauboussin explores how the “wisdom of crowds” works for some specific problems.

The article (and the book) look at the conditions under which crowds may do a better job of prediction than individual experts. Mauboussin writes:

Debate about the wisdom of crowds—the idea a collective can solve problems better than most individuals within the group, including experts—has percolated in recent years. While enthusiasts and detractors have made their case, much of the marshaled evidence is anecdotal. Even when the idea’s supporters specify the necessary conditions for the wisdom of crowds to succeed, there is rarely discussion of how it works.

While the question of collective prediction is important in a wide range of areas, readers of this site are interested in how this may be specifically applied to the stock market. One of Mauboussin’s thoughts on the topic:

Wisdom of crowds and market efficiency. A number of leading finance academics, including William Sharpe, Richard Roll, and Jack Treynor, have pointed to the wisdom of crowds as a plausible explanation for market efficiency. We are enthusiastic advocates for this view as well. The value of this approach is it reveals the conditions under which markets are likely to be efficient or inefficient.

There is obviously a great deal more going on in this piece and the book itself, and hope this whets your appetite for more.  We thought our readers, and especially fans of James Surowiecki’s The Widsom of Crowds would be interested in Mauboussin’s take on the topic.

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