Crowd Wisdom and the Lack Thereof

Financial markets are shaped by the paradox of collective behavior. On the one hand, dispersed individuals acting independently can generate remarkably accurate insights—a phenomenon popularized as the wisdom of the crowds. On the other, markets are prone to psychological waves of optimism and fear, what John Maynard Keynes famously termed animal spirits. Juxtaposing these two forces helps explain why markets are often efficient but occasionally spectacularly unstable.

The Wisdom of the Crowds

The idea that groups can be collectively “wise” has deep intellectual roots. Condorcet’s Jury Theorem (1785) argued that if individuals are more likely than not to be correct, aggregating their votes increases the probability of a correct outcome. A century later, Francis Galton (1907) demonstrated the accuracy of averaging estimates when a crowd guessed the weight of an ox. James Surowiecki’s The Wisdom of Crowds (2004) popularized these findings, noting that independence, diversity of opinion, decentralization, and effective aggregation mechanisms are the preconditions for collective accuracy.

In markets, this principle underpins the efficient market hypothesis. Thousands of investors analyze information independently and express their views through buying and selling. The price that emerges in the limit order book is not any single trader’s estimate but the aggregate of many. Prediction markets, where contracts on future events are traded, provide further evidence that groups can produce remarkably accurate forecasts when incentives align with truth-seeking.

The economic theory behind prediction markets is credited to economists Friedrich Hayek and Ludwig von Mises. Their work suggests that markets are a powerful "mechanism for collecting vast amounts of information held by individuals and synthesizing it into a useful data point". Long before modern markets, this principle was at work in early forms of political betting, with records dating back to 1503 in Europe and to 1884 on Wall Street for U.S. presidential elections. A more modern example is the Iowa Electronic Markets (IEM), a group of real-money prediction markets founded in 1988 for academic research. Despite the small sums involved ($5 to $500 per speculator), the IEM has often proven to be a more accurate predictor of political elections than traditional polls. The power of these markets, as with all "crowd wisdom" phenomena, comes from rewarding accurate predictions, providing incentives for research, and creating an algorithm for aggregating opinions.   

The Power of Animal Spirits

But independence and rational aggregation rarely hold perfectly. Keynes (1936) introduced the concept of animal spirits to capture the psychological impulses—confidence, herd behavior, even fear—that drive markets beyond fundamentals. Robert Shiller and George Akerlof’s Animal Spirits (2009) extended the concept, highlighting how narratives and social contagion can move markets.

When investors herd, independence is lost; when optimism or pessimism spreads contagiously, diversity collapses. Instead of prices aggregating dispersed information, they amplify collective mood swings. History is replete with examples: the dot-com bubble of the late 1990s, the U.S. housing bubble before 2008, and the 2021 meme stock frenzy. In these episodes, animal spirits overwhelmed informational efficiency, producing bubbles and crashes.

Markets Between Wisdom and Instinct

The tension between wisdom and spirits is central to understanding financial markets. At times, the crowd is wise: futures markets often forecast interest rate moves more accurately than central bank committees. At other times, the crowd is irrational: panic selling during crises drives prices well below intrinsic value.

A useful framing is this:

• Wisdom of the crowds explains why markets are often right.

• Animal spirits explain why they are sometimes spectacularly wrong.

Financial markets therefore oscillate between being efficient aggregators of dispersed knowledge and volatile arenas of collective psychology. Recognizing the conditions under which one force dominates the other remains one of the most important challenges for investors, policymakers, and researchers alike.

Conclusion: Social Networks and The New Frontier of Collective Intelligence

The timeless tension between the wisdom of the crowds and the psychological force of animal spirits has been reshaped by the modern digital age. Today's financial markets are increasingly influenced by social networks, which serve as a fertile ground for both forces to operate in real-time. A compelling case study is the financial trading platform eToro, which operates a social network feature that allows users to copy the trades and portfolios of others, creating a unique environment for studying collective behavior.   

Research into this platform has shown that social learning—the spread of trading ideas through a network—can be a powerful force for generating collective wisdom. The study found that traders in a "balanced network" with sufficient, but not excessive, social connections and "idea flow" were the most successful. These traders achieved an increase in return on investment of up to 30% compared to isolated traders. This demonstrates that a well-structured social environment can facilitate a "fractal dance" dynamic, which enhances the collective performance of the group by fostering meaningful exchanges and innovation.   

However, the same social networks that enable collective wisdom can also amplify the effects of animal spirits. The meme stock frenzy of 2021 provides a clear example, where social proof and fear of missing out (FOMO) became a self-reinforcing feedback loop. In this context, a social network can devolve into an "echo chamber," where a lack of fresh perspectives and an overreliance on a single narrative can lead to poor outcomes. The social-driven narrative and collective buying of GameStop, for instance, led to a rapid surge and subsequent crash that caused significant losses for latecomers.   

Ultimately, social networks represent the latest frontier in the ongoing battle between wisdom and instinct. They have the power to harness the collective intelligence of market participants, but they also carry the inherent risk of transforming into a single, cohesive herd driven by emotion rather than information. The insights from these new platforms reinforce a fundamental truth: the structure and psychology of a market's participants are just as important as its fundamentals in determining whether it will be a source of accurate price discovery or a volatile arena of speculation.

References

Condorcet, M. de. (1785). Essay on the Application of Analysis to the Probability of Majority Decisions.

Galton, F. (1907). “Vox Populi.” Nature, 75, 450–451.

Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money.

Surowiecki, J. (2004). The Wisdom of Crowds. Doubleday.

Akerlof, G. & Shiller, R. (2009). Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton University Press.