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Home > Socionomics
Why the Herd Cannot Buy Low or Sell High
The June Socionomist reveals why the "wisdom" of crowds does not apply to investing

By Nico Isaac
Wed, 27 Jul 2011 17:30:00 ET
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In 1907, an Englishman at a county fair observed that a group of independent opinions offers a better estimate than can any single individual in the group. Fast forward one century, and this idea grew into the theme of a popular book with a really long title: "The Wisdom of Crowds: Why the Many are Smarter than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations."

If this notion were true in the real world -- where people communicate with each other -- then collective wisdom would produce superior asset valuations. In other words: The herd would buy low and sell high.
 
But such is not the case. The June 2011 Socionomist explains why:
 
...herding becomes far stronger with respect to financial-valuation-questions -- which have only subjective answers. In 'The Financial/Economic Dichotomy in Social Behavior Dynamics: The Socionomic Perspective' (2007), authors Robert Prechter and Wayne D. Parker posited that humans naturally tend toward consensus -- especially under conditions of uncertainty -- because they have evolved to herd as a primal survival tactic…
 
The Wisdom of Crowd Effect becomes less useful or disappears when estimates converge due to herding. Groups tend to coalesce around select but uninformed opinions and develop increased confidence in those opinions….
 
Our socionomic model implies that social influence, opinion convergence, and increased confidence about the direction of prices all intensify near significant turning points. This is why money flows, sentiment indicators and studies such as Frazzini and Lamont (2006) show that investors tend to buy late into rallies and sell near market lows.
 
While extremely one-sided market opinion is slightly more prevalent during market advances, it is more focused at market lows, when fear and pessimism are also highly concentrated. Strong opinion convergence seems to be a better timing tool at lows than at highs. For example, Figure 2 shows that since 2000, the 30-period moving average of the S&P DSI (www.tradefutures.com), a poll of short-term S&P Futures Traders, has dipped below 22% bulls eight times, each time at an important low. This suggests that the strength of opinion convergence fluctuates with social mood at multiple degrees of scale.
 
In the uncertain realm of finance, one thing is always certain: To follow the herd is not the "wisest" strategy for success.
 
 
The Socionomist puts you ahead of tomorrow's news, zeroing you in on the important social trends that will shape your world in the foreseeable future. Each issue warns you about dangerous pitfalls and alerts you to exciting opportunities emerging from trends in society.
 
"You guys are on the cutting edge of a new way of seeing how the world works." -- Bill H., Socionomist Subscriber
 
We want you to put the predictive power of socionomics to work for you -- so you can stay one step ahead of social change.
 
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Tags: Robert Prechter, Daily Sentiment Index (DSI), herding, Robert Prechter, socionomics, wisdom of crowds
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