(This article first appeared in Real Estate Investor's Monthly.)

Businessweek called James Surowiecki’s The Wisdom of Crowds the Best Book of the Year.

Its core observation is that, in many situations, crowds make wiser decisions than even the smartest individuals within that same crowd. Consequently, anyone who has occasions to make decisions ought to wonder if this phenomenon can be harnessed to improve their decision-making. Do real estate investors make decisions? You bet.

Democracy & juries

Democracy and juries are crude examples of the application of this fact. Actually, according to the book, they are garbled, incorrect applications of the wisdom-of-crowds effect.

For one thing, the wisdom of the crowd works only when each member of the crowd makes their decision independently. In elections and juries, some people try extremely hard to persuade others. That reduces the wisdom of the crowd to the wisdom of the opinion leaders. In other words, juries would produce better decisions if they listened to all the evidence but did not deliberate with each other.

Jelly beans

The phenomenon of crowds being wiser than all or almost all of the members of the crowd was first discovered in contests to calculate the weight of an ox or similar quantity-estimation competitions.

A question that I have, but author Surowiecki seems somewhat less interested in, is whether this phenomenon applies only to quantity estimation.

Some rules

I complained in my review of Malcolm Gladwell’s book Blink that he was content to observe an interesting phenomenon but not derive useful rules from it. Although Surowiecki and Gladwell seem to have a mutual admiration society, Surowiecki at least tries to derive the rules. Here they are:

1. Group members must have at least some knowledge of the subject matter. They cannot be just guessing without any knowledge.
2. They must have some incentive to try to get the right answer; otherwise, they may just throw out random answers. The wisdom of crowds comes from their collective knowledge and effort; therefore, there must be both knowledge and effort in every participant.
3. The members of the group must be diverse. A group of clones who were extensively trained in how to solve a particular problem will all come up with the exact same solution so only one representative of their group should be included.
4. As stated earlier, the members of the group must decide independently of each other. To the extent that some follow the lead of others in the group, they nullify their own unique knowledge, intellect, and diversity, thereby rendering themselves disqualified to make the group decision better.
5. To the extent that the members of the group have some central connection—like they all work for the same organization—that central control must be eliminated for the purpose of obtaining the collective wisdom of the group—perhaps by secret ballot. A room containing a boss and eight yes men does not produce wiser decisions than the boss alone.

Mobs

Obviously, these rules are what separate wise crowds from crazed mobs like lynch mobs, stampeding groups running away from perceived danger, or mobs bent on vandalism. Mobs not only have zero wisdom, they have negative wisdom, behaving instead like rabid or panicked animals.

Another famous book about crowds was Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds which came out in 1841. Mackay chronicled the crazy behavior of various crowds. The other famous book on crowds, Gustave Le Bon’s 1895 The Crowd: A Study of the Popular Mind was anti-democracy and used mob behavior to argue against it.

Crowds not always better

Make no mistake, Surowiecki’s message, and mine, is not that crowds are always wiser than individuals. Mobs, committees, and juries and other groups are capable of astonishingly bad judgment. Rather, the point is that UNDER CERTAIN CIRCUMSTANCES, groups make better decisions than even the wisest individuals in the group.

3 kinds of problems

Surowiecki focuses on the use of crowds to solve three types of problems:

• cognition
• coordination
• cooperation

Real estate investors encounter all three.

Consensus and compromise

Consensus and compromise suck in the context of group decisions. They are political maneuvers to make achieving a decision easier. They most certainly do not contribute to better decisions and, in fact, do precisely the opposite, essentially ceding the decision to the most politically powerful members of the group.

Markets

Markets like the stock market would at first glance appear to be almost ideal crowd wisdom extracting machines. Indeed, a number of very successful commercial ventures, like Google’s search-engine algorithm, Wikipedia, and the Iowa Electronic Market election forecasting service, rely on the wisdom of crowds to achieve their extraordinary results.

The problem with some markets like the stock market or the real estate market is that the decisions of the members of the market are not independent. Markets often turn into crazed mobs where each member is dramatically influenced by the other members of the mob resulting in bubbles and crashes unwarranted by underlying facts.

To put it another way, crowds cannot accurately forecast market prices. They can accurately recognize logical, fact-based correlations, but markets are partly logical and partly mob psychology. Neither crowds nor anyone else can forecast mob psychology.

Less intensely led

It appears that markets, like the stock market, work when they are far less intensely discussed by opinion leaders like TV and radio personalities.

For example, the betting lines or point spreads in gambling are essentially markets. The house needs to keep the amount of money bet on each side equal to avoid house losses. They constantly adjust the point spreads as the bets come in to prevent a majority of money from being bet on one team. It seems to work. The crowd favorites win about 72% of the time and the betting lines are the most accurate available forecast of team success—beating all the experts from Sports Illustrated’s Dr. Z to numerous other experts who publish their “picks.”

Cronies vs. new guys

The bad gurus are big on advocating your building a “power team” of great local advisors. I never did that and do not know any successful investors who did, but it sounds logical and right to newbies and is really a hand-holding mechanism that enables bad gurus to sell expensive seminars and mentoring to the scared.

Surowiecki says homogenous “dream teams” that rarely admit new blood are generally lousy decision makers. The President’s cabinet comes to mind, as do corporate boards. If the dream team are all members of some organization like a company or athletic team coaching staff, political appointees, or non-profit organization, they are likely to be somewhat isolated from outside perspectives and ideas.

I expect that some subscribers to this newsletter may have such teams around them. Reconsider their use.

Expertise

You would think that the best group would be a team of top experts. Once again, the Cabinet comes to mind. In fact, empirical data indicates that the expertise of the group does not matter as long as it’s above zero. What the group needs is embodied in the rules stated above, not high levels of individual expertise. Expertise often is offset by lack of openness to new ideas on the part of the experts. Experts are particularly bad in forecasting change—perhaps because they were trained in the past and their expertise is based on the past.

Courage

One of the advantages of diversity is it increases the courage of each group member to say what he really thinks. In other words, the new guys let the existing group members perform better.

Once again, the properly constructed and organized group generally outperforms each and every one of its members, including the biggest expert in the group on the subject in question. Expertise is nice, but diversity of perspective and freshness are underrated and better.

Informal group decisions

Not all the wisdom of crowds manifests itself in organized polls. A traffic jam is a wisdom of crowds situation. So are pedestrians moving in all directions on a crowded city streets. Although they are not verbally communicating with each other, they are communicating silently by their actions.

Some have studied pedestrian traffic in crowded cities and found it to be an almost balletic feat of group coordination as pedestrians change speed and directions without collisions in close quarters producing remarkably efficient movement of the crowd as a whole.

Vehicle traffic is less efficient but there are a still a great many good decisions being made like staying put until after rush hour or taking an alternate route. This is informal coordination.

Cooperation is a topic I have covered in previous articles on game theory which is about alternating between cooperation and competition. “Co-opetition” some have called it. It makes sense in many cases and is widely observed in the animal world.

Your crowds

What crowd wisdom can you tap into? Continue to avail yourself of Internet crowds like Google and Wikipedia, while remaining mindful of the five criteria that must be met.

You can and probably should create your own Internet groups to ponder various decisions you have to make. During my three years of litigation with one of the gurus I criticized, I posted as much detail about the case on the Internet as possible and asked readers for help. The information I got from visitors to the Web site was amazing and invaluable. To an extent, my site became a sort of Wikipedia on that guru. The group wisdom exceeded mine and that of any single expert or group of experts I could have found.

For reasons I am not sure about, my Web site (www.johntreed.com) ranks in the top 1% of all the Web sites in the world by traffic (according to Alexa.com). The greater your traffic, the greater the wisdom of your crowd of feedback givers. Sorry, but I do not know how to tell you to increase traffic.

Be careful that any local crowds you rely on, like your staff or team of outside advisers, are also complying with the rules. Disconnect the centralization caused by your leadership of the group by way of secret ballots or at least insisting on courageous group members who will truly speak their minds rather than maneuver politically for your favor.

I have long been a big booster of real estate investor clubs. They can be used for this purpose, but again, be careful about following the rules. There are dangers of lack of independence, centralization, and lack of diversity. For example, typically such groups have lots of members who attended seminars given by the same gurus.