Michael Mauboussin: Beyond Market Efficiency: Diversity, Incentives, and the “Wisdom of Crowds”

In his recent interview with Bloomberg, Michael Mauboussin compares market efficiency to a “wisdom of crowds” phenomenon, where diverse perspectives, information aggregation, and proper incentives lead to good collective decisions.

However, there’s also a “madness of crowds” lurking when these conditions are violated. The most likely culprit? Lack of diversity in thinking, creating situations where everyone aligns their views and blind spots amplify.

Diversity loss may even trigger sudden negative consequences like ecological shifts. Therefore, market efficiency is not a smooth, linear concept, but rather a complex, non-linear function where small changes can have big impacts.

Here’s an excerpt from the interview:

Mauboussin: It probably is. I think the way I think about market efficiency is really the notion of wisdom of crowds.

And when a crowds smart you need three conditions:

1. Diversity: So heterogeneous points of view

2. Aggregation: Some way to bring that information together, exchanges do that perfectly

and,

3. Incentives: Which are rewards for being right and penalties for being wrong

So that’s the wisdom of crowds. Well, we know there’s the madness of crowds too.

So how does that come about? And the answer is, when one of those three conditions are violated.

And by far the most likely to be violated, is diversity. So rather than us thinking independently, we correlate our views.

And so that’s, I think the biggest thing we need to think about is when are we all thinking the same way? When are we all standing on the same side of the ship?

There’s a fascinating dimension about diversity by the way as a side note is, you can lose diversity in a system and nothing happens, happens in ecologies as well, but just a small incremental change and all hell breaks loose.

So this wisdom of crowds, the madness of crowds, is not like a straight line. It’s sort of a nonlinear function, which is really interesting and part of why it makes it so surprising and difficult for us to deal with.

You can listen to the entire discussion here: