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The wisdom of crowds can be seen at the racetrack, where the odds on horses coincide very nicely with their probability of winning. (That is, if you look at a large collection of horses that went off at 4-1 odds, you find that 20% won.) And, of course, collective wisdom is also at work in markets, which is why it's so hard to outperform the market over time. Just as Google's PageRank encapsulates the knowledge of Web users, so does a market price embody, as the economist Friedrich Hayek suggested, all of the tacit knowledge and wisdom of investors and traders.

Of course, markets are also known for being subject to manias and panics, fads and mass hysterias. Why do these occur? For the crowd to be intelligent, the people within it have to be making decisions on their own, while drawing on diverse sources of information. During a bubble or panic, people's decisions become dependent on others'--"If they're selling, I better sell, too"--and diversity vanishes as people get caught up in the prevailing frenzy. But a crowd is wisest, it turns out, when its members act independently.

Google's success, then, is far from an interesting quirk. Instead, it's relevant to just about any problem-solving situation. As long as you're asking a question that has a right answer--including questions like, "Should we acquire this company?" or "Is there a market for this new product?"--and as long as people are making judgments on their own, collective intelligence will get you the best answer possible. Google, and it shall be given.

Reference:

The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations by James Surowiecki. Posted by Greg Ransom | TrackBack