This book is as good a primer as any to the Dumb Agent Theory, so it is with great pleasure that I write a review of it on this site:

The Wisdom of Crowds
By James Surowiecki
Anchor Books, 2005. 306 pp., $10.17

The message of this book, in a nutshell, is that groups are more intelligent than any one individual of that group, even so-called experts. This is a very interesting premise, negating such common assumptions as “dumbing down of the masses” or “a person is intelligent, people are dumb” and others. Once again, this concept, used in finance and economics, is the foundation for the Dumb Agent Theory and is more easily explained with examples than with theory. I will state a couple of the more interesting examples from this book, after which I will give some brief commentary.

USS Scorpion

One famous example mentioned in the book is that of the U.S. Submarine Scorpion, which disappeared in the Northern Atlantic in 1968. A search had to be launched, but the problem was that no one knew why the submarine had gone down, nor where. The search area was about 20 square miles and thousands of feet deep; an almost impossible task. The curious part came when the officer John Craven decided to ask everyone about the potential whereabouts of the missing submarine rather than consult three of four top experts. He assembled everyone he could think of with related knowledge: mathematicians, submarine specialists, oceanographers, etc., and instead of asking them to work together, he asked each of them to give their best guess as to where the Scorpion would be.

Neither one of the guesses would be accurate, and he understood that, but he thought that if he gathered all of the accumulated data to find an “average point” (which he did using Baye’s theorem) he would be able to pinpoint a location. When the submarine was found, it was barely 220 yards from where the guessed location had been.

Challenger Disaster

The other famous example is that of the Challenger disaster in 1986. After it occurred, NASA’s expert committee needed several months in order to find the cause of this event, at first blaming the explosion on the space shuttle’s external tank manufactured by the Martin Marietta corporation. The markets, however, gave their verdict immediately: Morton Thiokol, manufacturer of the faulty o-rings, quickly received a 12% loss in share price, while other shuttle contractors remained relatively free of market punishment. The final confirmation came six months later when the NASA committee charged with investigating the event found that only Morton Thiokol’s o-rings were to blame, exonerating all the other companies. The experts took six months to find the answer but the markets ‘knew’ it all along.

A Few Comments…

While DumbAgent.com may be seen as biased in reviewing this book, this being the premise for our underlying theory, it might be interesting to look at a few shortcomings. First of all, many points are given in favor of the Wisdom of Crowds (understandably), but some obvious questions are not answered. For example, if crowds are so intelligent why do collective decisions still turn sour (such as those leading to wars) and why do so few people win the lottery (although this is not a collective decision, and therefore easily refuted). He also mentions that the correct value of a stock should represent a company’s value in twenty years’ time, but gives no examples of how accurate of a yardstick this has been.

Another point that he brings up is that bubbles only occur in markets and that they will never occur in anything else, except with maybe arts and antiques. It is interesting to observe how just two years later, a bubble would occur in real estate, proving this point wrong. In all fairness, however, the reasons he gives still hold. He says only when goods are bought to be sold later (such as with stocks, as opposed to, say, apples), can bubbles occur. People are willing to pay more than the perceived value as long as they believe other people will pay even more at some point in the future. This is exactly what happened with the residential real estate market so, quite frankly, the thesis is still very much valid.

All in all, this is a very good primer for anyone interested in market efficiency, financial and economic theory, in decision making theory and, obviously, in the Dumb Agent theory. Highly recommended.

You can buy this book, as well as others we recommend, from our Store.