Illusionist Derren Brown recently started a media frenzy in Britain by apparently “predicting” the lottery numbers on live TV. In an alleged explanation of his feat Brown claimed to have averaged the predictions of 24 people, citing Francis Galton’s discovery that the combined estimate of a crowd is often more accurate than any of the individual estimates.

While it’s unlikely this approach can successfully predict lottery numbers, Brown’s trick has introduced a mass audience to the phenomenon explored in James Surowiecki’s The Wisdom of Crowds.

In financial and investment terms the wisdom of crowds is a re-statement of perfect market theory, ie that at any time the market price accurately reflects value based on all publicly known information as indicated by the combined behavior of all participants (ie the crowd). It also implies the adoption of a “trend is your friend” approach to investment, buying into a rising market and selling when prices are falling.

The crowd cannot beat the market, because the crowd is the market. Therefore those who purchase index trackers and ETFs also subscribe to the wisdom of crowds.

But the crowd isn’t always right. Witness the crashes that inevitably follow sustained bull markets, and the volatility seen in the past year or so in the wake of the credit crunch.

An alternative view was presented in Charles Mackay’s 1841 classic Extraordinary Popular Delusions & the Madness of Crowds which outlines such mass errors of judgment as the South Sea Bubble and the Dutch Tulip fiasco. Human psychology hasn’t changed much since as revealed by the dotcom crash and the sub-prime mortgage crisis and subsequent credit crunch… Subscribers to the mad crowd theory tend to a contrarian approach to investing, finding what the crowd is doing and going in the opposite direction.

In reality neither approach guarantees success. Financial decision making isn’t about what the crowd’s doing today; it’s about predicting what the crowd will be doing at some point in the future! That said, knowledge of what the crowd is doing is a significant input to the decision making process, but it should be considered alongside other inputs, and that all important instinct or gut feeling.

Recommended reading

The Wisdom of Crowds New Yorker business columnist James Surowiecki explores a deceptively simple idea: Large groups of people are smarter than an elite few, no matter how brilliant â€“ better at solving problems, fostering innovation, coming to wise decisions, even predicting the future. Surowiecki ranges across fields as diverse as popular culture, psychology, ant biology, behavioral economics, artificial intelligence, military history, and politics to show how this simple idea offers important lessons for how we live our lives, select our leaders, run our companies, and think about our world.

Extraordinary Popular Delusions & the Madness of Crowds Charles Mackay’s classic work about grand-scale madness, major schemes, and bamboozlement – and the universal human susceptibility to all three. This informative, funny collection encompasses a broad range of manias and deceptions, from witch burnings to the Great Crusades to the prophecies of Nostradamus.