Alec Schmidt

ML Score
Financial Risk and Engineering, NYU School of Engineering | Adjunct Professor
In 1907 English polymath Francis Galton published an account of a forecasting competition that had taken place at a country exhibition in Plymouth the year before. He described how 787 participants had attempted to win prizes by correctly guessing the weight of a slaughtered ox. After reviewing the entries, Galton observed that the median guess was within 1% of the actual weight. This remains one of the foremost examples of the idea of the wisdom of crowds, whereby combining a diverse array of independent opinions can lead to robust forecasts, often superior to those made by any individual. It is easy to see why the wisdom of crowds is a compelling description of how equity markets operate and why they might be efficiently priced. We have a vast array of distinct investors making independent judgements. Doesn’t that get us to a similar situation to Galton and the ox? Not quite. As we know only too well, crowds are not always wise. There are several characteristics required before we can begin to value their wisdom. The critical features for investors are: diversity of opinion and independence from other participants. Although it may seem that the sheer number of participants inequity markets guarantees that prices reflect a varied range of perspectives, there will be times – particularly during market crashes or bubbles – where investor focus becomes trained on a very narrow set of ideas and issues. It is in such febrile periods where investor decisions are most likely to be influenced by the behaviour of others. Extreme events in markets will begenerated and sustained by the shared stress, fear and excitement of the crowd. It is not simply these bouts of dramatic crowd behaviour thatprevent the market being efficiently priced. There is something else. Galton’s ox and other similar examples (such as judging the number of sweets in a jar) work because everyone involve