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Lindley Estes is a business writer for The Free Lance-Star and This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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Wisdom of crowds isn’t always so wise

JAMES SUROWIECKI’S 2004 book "The Wisdom of Crowds" offers a great explanation on why it’s so tough for professionals to beat a stock market index fund.

Whether it’s predicting the number of jelly beans in a jar or figuring out the proper price of a stock, Surowiecki shows that large groups of independently minded people voting alone tend to get it right on average.

Therefore the stock market is typically "efficient," meaning it properly values companies most of the time. It’s therefore hard to beat an index fund composed of every stock in the market.

But markets aren’t always efficient. Surowiecki shows in his book that when investors stop acting independently and start mimicking each other, that’s when irrational swings up and down occur in the market.

That "herding" tendency is part of what’s causing the recent extreme volatility in the stock market, Surowiecki argues in a column that appears in the Sept. 1 edition of The New Yorker.

Since the beginning of July, there have been six days on which the Standard & Poor’s 500 has gone up or down by at least 2 percent. By contrast, between 2004 and 2006, daily moves of 2 percent occurred on just two days. Moves of more than 1 percent have gotten routine.

"In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we’ve weathered the storm," Surowiecki writes.

Surowiecki shows that humans and other animals tend to herd together for protection during times of uncertainty, such as what is now occurring with the credit crunch. So market professionals mimic their peers–buying when they buy, selling when they sell.

Another factor leading to the volatility is that market professionals are overconfident, Surowiecki argues. Investors who think highly of their abilities tend to trade more during times of increased uncertainty. Traders who have lost a bundle bet big to recoup losses.

"The result is that an individual stock can move up or down ten percent on a day with no real news," the column states.

In some sense this extreme volatility is irrelevant for the buy-and-hold investor. A chart of the S&P 500 shows that, despite a lot of zigs and zags, the index remains about where it was two years ago. An investor who didn’t look at his portfolio for two years wouldn’t know what all the fuss was about. But few operate like that in reality.

Some skilled investors with solid convictions enjoy market volatility because it gives them an opportunity to buy at better prices. But Surowiecki says market volatility makes ordinary investors "less inclined to trust markets." That "risk aversion" makes capital more expensive for businesses, homeowners and more.

Surowiecki has shown that crowds are usually wise. But not always. Current market volatility suggests this is a time when we must question the wisdom of the crowd.