The Wisdom of Crowds and the Stupidity of Herds: Lessons for Policy and for the Classroom |

The Wisdom of Crowds and the Stupidity of Herds: Lessons for Policy and for the Classroom

Psychologists have regularly expounded the presence of systematic biases in individuals’ decision-making processes. Examples include the exhibition of excessive loss aversion, resetting of reference points, and a preference for the status quo. In the presence of existing biases, group decision-making is often a significant factor in exacerbating an individual’s behavioural propensities. This was the core of the public lectures by Prof. Richard Zeckhauser of Harvard University at the Lee Kuan Yew School of Public Policy.

The economist’s paradigm rested on theories of rationality and utility-maximisation to analysing individual decision-making and behaviour. Rational analysis implies that probability is a critical factor in any decision made. Individuals construct a probability and payoff based on the available information, not how the decision problem is constructed or the source of uncertainty. At each point in time, they will refine their estimates depending on how useful any additional information is.

Investment decisions are typically made on individual preferences and probabilities, and it is well-known their assessments can be poor. In the financial world, improper decision-making on investment decisions can, and will, often have severe consequences. The present economic environment post-2008 financial crisis is a case-in-point. The good news is that individuals do become more competent in their assessments with time, practice, and a constant updating of information. Thus, in the presence of efficient markets, investment performance and returns ultimately reflect market fundamentals.

Yet, financial markets are known to exhibit significant anomalies. Markets have been known to fluctuate in magnitudes beyond what efficient markets and investor rationality were able to predict and explain. The competing argument for this is that some form of decision-making bias is potentially present, thus contributing to the excessive fluctuations.

Behavioural finance offers an overarching model which espouses both theories of decision-making. It provides a significant degree of ability in explaining the movement of financial markets in 2008 and before. In particular, it was argued that crowding and similar forms of group decision-making could have been a significant contributor to the observed volatility. As an illustration, Prof. Zeckhauser drew on examples such as many in the financial world who placed large investments on financial instruments they did not understand. A group process was suggested here as each financial institution plausibly followed the intuition that if the next was doing it, they were probably ‘doing something right’. What this did was reinforcing the belief that the financial undertaking was a sensible one, even if it was not.

However, using groups in decision-making processes allows for the collective presence of a large amount of knowledge and information. Effective use can entail superior decisions being made. The flipside of this is that many methods of aggregation, costly actions in conveyance, and personal rewards all entail a loss of informational content. A particular prevalent form of information loss results from a tendency to subscribe to herding, where individuals may change their actions so as to place themselves closer to what may be the group’s ‘consensus’.

Specifically, herding is a social phenomenon which can be rational to undertake on an individual basis, but it need not so collectively. It can also prevent revealing one’s true intent or opinion—there is often implicit pressure against raising disagreements. This makes it difficult to know the group’s true preferences; herding may also encourage models and evidence which may be detrimental for everyone. Decisions made based on such beliefs subsequently result in a socially inferior outcome.

Besides herding, another behavioural characteristic which can often impede the decision-making capacity of individuals is the aversion to uncertainty or, more specifically, ambiguity. Risk and ambiguity differ: the former has objective tools of measurement, and it is possible to obtain objectively probabilistic outcomes. In reality, this is not often present. In contrast, ambiguity is assessed on each individual’s subjective probabilities, and some part of this incorporates an ignorance present in each person.

Thus, an individual exhibiting an aversion to ambiguity often discounts an unknown probability. This form of behaviour has been used to explain issues such as the home market bias in investment, the value of established brands, the under-diversification of incomes risks, etc.

Often-overlooked in taking on an ambiguous option is that it offers the possibility of new choices and can potentially reveal new information for better decision-making in the future. However, people also tend to be poor at recognising such opportunities. They mistake ambiguity aversion for caution. They may also fall prone to probability neglect; it has been established that anxiety can impede one’s ability to think objectively, thus neglecting any consideration of probability.

While behavioural biases cannot be removed completely, Prof. Zeckhauser did offer suggestions by which individual decision-making can be improved. Knowledge of the situation and oneself is a first-step towards this. Constant self-reflection and recognition of biases such as overconfidence and herding, and the subsequent re-aligning of any assessment to take these into account will, while not eliminating, ultimately aid towards better decisions being made. 

Prof. Richard Zeckhauser, the Frank P. Ramsey Professor of Political Economy at the John F. Kennedy School of Government, delivered the Hong Siew Ching Distinguished Speaker Series lecture at the Lee Kuan Yew School of Public Policy on 7 February 2013 on ‘Behavioral Finance’. This was followed by a public lecture on ‘Group Decision, Ambiguity, and Probability Blindness’ on 8 February 2013. Both lectures were chaired by Professor Jeffrey D. Straussman, Vice Dean (Executive Education).

 

By Kwan Chang Yee, a Research Fellow at the LKY School of Public Policy.

 
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Speaker(s):

Prof. Richard Zeckhauser, Frank P. Ramsey Professor of Political Economy, Kennedy School, Harvard University

Date:
Friday, 08 February 2013
Time:
12:15 p.m. - 1:30 p.m.
Venue:

Seminar Room 3-5
Level 3, Manasseh Meyer, 
Lee Kuan Yew School of Public Policy, 
469C Bukit Timah Road, 
Singapore 259772

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