In the aftermath of last week’s Brexit referendum many denounced the English vote with a mix of derision and indignation: the old and the uneducated crowds destroyed the European dream for everyone else. But would democracy be better if it were restricted to the best educated segment of the population? Let’s consider the idea of “wisdom of crowds.” This mysterious and utterly fascinating concept suggests that humanity evolved to be collectively intelligent and that the crowds tend to be more intelligent than the most intelligent of its members. If you have not yet come across this, prepare to be amazed (and keep an open mind):

In 2004, author James Surowiecki published a fascinating book titled “Wisdom of Crowds,” a deliberate inversion of Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds,” written 163 years prior. In his book, Surowiecki compellingly presents the idea that collectively we tend to be more intelligent, more accurate and better problem solvers than we are individually.

In the Victorian era, Western scientific community held a condescending view of the average person’s intelligence. In addition to Mackay’s influential Madness of Crowds, French writer Gustave Le Bon wrote “The Crowd: A Study of the Popular Mind,” in which he expressed pessimism about men’s intelligence and dismay at the idea of democracy – ordinary people wielding political influence – as it arose in the West. This general attitude led the English statistician Francis Galton to write how, “the stupidity and wrong-headedness of many men and women [was] so great as to be scarcely credible.”

But at the ripe old age of 84, Galton was about to make his most astonishing discovery. At a country fair in Plymouth, he came across a weight-judging competition where an ox was placed on display and visitors were offered to wager on the animal’s weight. Best guesses would receive prizes. Eight hundred people placed their wagers including many individuals with little or no expertise in livestock. Galton later wrote in the scientific journal Nature, that the “average competitor was probably as well fitted for making a just estimate of the dressed weight of the ox, as an average voter is of judging the merits of most political issues on which he votes.” Galton was keen to underscore the average voter’s ineptness, but what he found was exactly the opposite: the crowd – their average guess – got the almost exactly the right answer, guessing the ox’s weight at 1,197 pounds, just a pound short of its measured weight, which was 1,198 pounds – a negligible 0.08% error!! Surowiecki proposes that, “under the right circumstances, groups are remarkably intelligent, and are often smarter than the smartest people in them,” and offers several eerily fascinating examples.

The Search for the Scorpion

One of them was the United States Navy’s search for the submarine Scorpion which disappeared in the North Atlantic in May of 1968. The Navy found itself with an impossible task of combing over an area measuring 20 miles across and thousands of feet deep. One naval officer decided to consult a group of men with wide range of specialties and ask them to guess where the submarine might be (offering a bottle of whiskey as a prize). He then used a mathematical formula to calculate the average answer and the submarine’s final location. While this calculated location was different from any individual guesses, it turned out to be only 200 meters from where the Scorpion was subsequently found. The amazing thing was that the data that the group had to base their guesses upon was close to nothing. Writes Surowiecki: “No one knew why the submarine sank, no one had any idea how fast it was traveling or how steeply it fell to the ocean floor. And yet, even though no one in the group knew any of these things, the group as a whole knew them all.”

Finding the culprit for the 1986 Challenger disaster

One of Surowiecki’s examples involves the work of collective intelligence in securities markets. On 28 January 1986, 73 seconds into its flight, the space shuttle Challenger exploded over the Atlantic Ocean off the coast of central Florida. Challenger’s launch was largely the work of four major NASA contractors, all four publicly traded companies: Rockwell International, Lockheed, Marin Marietta and Morton Thiokol. On the day of the Challenger disaster, each contractor’s stock price started dropping some 30 minutes after the explosion, before most people even had the time to digest what had happened. One firm was hit harder than others: within an hour of the explosion, Morton Thiokol’s stock was down 6% and its trading had to be halted. After trading resumed, its stock continued falling and by the end of the day, it was down 12%. By contrast, the stock of other three contractors rebounded and closed with a loss of only about 3% for the day.

The reasons why the stock market singled out Morton Thiokol weren’t clear; on the day of the disaster, there were no public comments declaring that Morton Thiokol might be responsible for the incident. On the following day, rumors about what had happened published in the papers did not implicate Thiokol either. In fact, it was fully six months after the explosion that investigators concluded that the Challenger blew up due to the O-ring seals on booster rockets built by Morton Thiokol, and that the other three contractors were not liable.

I must confess that I found this account hard to believe and as I read it, my immediate thoughts were that Morton Thiokol insiders must have dumped their shares in a thin volume session and as the price started dropping, other participants may have followed suit and that’s how the stock ended up battered. However, an analysis of the episode by finance professors Michael T. Maloney and J. Harold Mulherin cited by Surowiecki found that insiders did not sell their stock on that day. In fact, Maloney and Mulherin were entirely unable to come up with a convincing explanation for why Morton Thiokol stock was singled out by the stock market. It may well be that the market, in its mysterious collective wisdom somehow knew the relevant truths and set asset prices accordingly.

These examples stand in stark contrast with the idea of popular delusions and madness of the collective mind as well as the bubbles and manias we periodically experience in securities markets. But as Surowiecki notes, wisdom of crowds only works if certain conditions are met. These are: (1) diversity of opinion, (2) independence (individual opinions aren’t influenced by opinions of others), (3) decentralization (information isn’t filtered), and (4) aggregation (some method for converting a multitude of individual judgments into a representative collective judgment). I would also add that the information available to the individual decision-makers must be true and not distorted. Unfortunately, the second and third of these conditions (independence and decentralization) are easily distorted in today’s information universe, particularly in securities markets.

Information is usually aggregated and reported by specialized organizations (how else could we know – for example – the unemployment rate in the U.S. economy), and the participants regularly make decisions that are informed by other participants’ decisions. As a result, where security prices should theoretically settle at some equilibrium level, market price discovery process instead generates crashes, trends and bubbles, defeating our collective intelligence, rendering expertise ineffective, and periodically giving rise to episodes where collective intelligence morphs into outright madness.

Regarding Brexit…

In contemplating British voters’ decision to exit the European Union, these insights should give us pause before we declare the crowd inept, uneducated, racist, misguided or irrational. It may just be that the crowd has got it right and that our own views are misguided. At any rate, an educated person should cultivate healthy respect for the democratic rights of uneducated people. “Uneducated” does not mean stupid any more than “educated” means intelligent. As Thomas Jefferson put it in his time, “State a moral case to a ploughman and a professor. The former will decide it as well and often better than the latter because he has not been led astray by artificial rules.” Noam Chomsky perhaps put it even more bluntly:

the educational system is very highly geared to rewarding conformity and obedience… it is kind of a filtering device which ends up with people who really honestly – they aren’t lying – internalize the framework of belief and attitudes of the surrounding power system in the society.

Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.