The Wisdom of Crowds and the Anatomy of a Panic

Major asset markets are generally too large to be overly influenced or pushed around by any one participant, and so are characterized as reflecting the wisdom of the crowd. This is thought of as a positive, as individual participants value different things, have different utility functions and approach and weigh the same incoming information in different ways. The net result, through different individual buys, sells and portfolio shifts gives the ‘best’ value at any one point.

We read an interesting exchange from polymath Sam Harris on the wisdom of crowds the other day that got us thinking about how this works in reality over fairly short, but significant, periods in markets. While the wisdom of crowds notion is true over the medium term, over shorter periods, some participants do cause flows that overwhelm. The events of early 2018 are a good example. The exchange is below; Harris had spoken at an event the previous night in New York with psychologist and economist Daniel Kahneman.

Frank Villavicencio: Sam. I attended & enjoyed it but didn’t get to ask my question: your take on collective decision making. Given the many identified flaws in our individual cognitive abilities, should we consider humans as more optimized for collective, swarm-like decisioning?

Sam Harris: The crowd is only wise when individual errors are uncorrelated. When correlated—as is the case when specific biases are widely shared—there’s no safety in numbers.

Hits the nail on the head. When the errors are correlated, you don’t have a crowd, you have a mob.

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Trend Follower Agonistes

A recent Bloomberg News article (https://www.bloomberg.com/news/articles/2019-03-01/one-of-wall-street-s-most-popular-trading-strategies-is-now-failing) mourned the passing of a venerable quantitative trading strategy – Trend Following.  The central claim of the article is that the strategy is antiquated relative to the speed and variability of modern markets.  We have been doing this for 40 years – it’s not the first time we have heard this. There is no denying that trend following has struggled, but we think the article has the reason exactly backwards.

The investment world’s conception of trend following has changed over the years.  Practitioners of the craft were, in the 70’s and 80’s, viewed as highly skilled magicians, teasing returns out of the tangled chains of futures markets, worthy of fees supporting retirement owning Major League Baseball teams or living in mansions in Mayfair.  Starting in the late 1980s, investors began to think about trend following in risk premia terms, reproducible factor returns – more science less magic.  Like other risk premia, trend results are highly variable (see our view on risk premia here – https://blog.mtlucas.com/2019/02/28/looking-beneath-the-hood-of-factor-investing), with recent trend returns on the downside of that variability curve.  We thought we would take a closer look at what is driving those lower returns, and why and when they may change.
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