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In The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations, James Surowiecki identifies and discusses the three conditions necessary for a crowd to make good group decisions. Applied to the stock market, good decisions means stock prices that reflect the true values of underlying assets. As depicted in the figure below, the three conditions are:
Independence of action: Those buying and selling must be largely independent of one another. When participants coordinate or collude, the resulting prices are less likely to be the "true" values of the stocks. For examples of things that might reduce investor/trader independence, see our blog entries of 2/6/05 (effects of attention-grabbing events), 12/29/04 (media impact on buying/selling), 11/12/04 (the Fed Model meme), 10/30/04 (implicit coordination of individual investors) and 10/9/04 (herding).
Diversity of perspectives: Those buying and selling must represent a broad range of backgrounds and attitudes. When participants are very much alike, the resulting stock prices are less likely to be "correct." The ownership of the stock of a company with small capitalization might lack diversity. The ownership of a stock that is very heavily shorted might also be relatively low in diversity. See our blog entry of 12/20/04 on the dynamics of diverse (but still rational) beliefs in shaping market behavior.
Private information: Many of those buying and selling must possess relevant private knowledge (not be noise traders). Uninformed trading is less likely to produce "correct" prices. See our blog entries of 2/25/05 and 2/24/05 for discussions of informed versus uninformed trading.
In summary, situations involving herded traders and/or a small number of shareholders are good candidates for producing mispriced stocks.
We do not recommend The Wisdom of Crowds specifically for its stock market coverage, which is thin and unsophisticated. The book overall is moderately interesting, but the full title overreaching.
For reviews of the outputs of other market experts, browse Guru Grades and Reviews of Web Sites and Books.
