Comments on: Every picture tells a story

By: James Surowiecki

James Surowiecki — Fri, 23 Jan 2004 20:17:32 +0000

Daniel, the question of who constitutes the “group of price-setters,” as it were, is a crucial one, and one that I haven’t answered in a way I’m fully happy with. I’d say it’s somewhere between Steve Ross on the one hand and the Amazon Indians on the other. More seriously, I think at the very least the group of price-setters for an individual stock has to include all the people who currently own the stock, and I think it should probably also include also those who are contemplating buying it. (Some economist, whose name I can’t remember, has an interesting, if maybe obvious, piece about how money managers give different stocks different levels of attention, so that there are those stocks they own, those they’re actively following, those they’re paying attention to in a loose way, and then those that they’re paying no attention to at all. I think anyone who’s doing one of the first two things belongs in the group, and maybe people who are doing the third do as well.) I agree that this requires a different sense of “cause” than most economists use, but I don’t think it’s so rarified (at least not if you delineate the group carefully enough) as to be wrong or useless. The difference for me between investors in a stock and the Iraqi people is that there’s an enormous cost to trying to overthrow Saddam, so that the lack of a rebellion doesn’t prove anything about what the Iraqis really wanted. There’s no cost—practically speaking—to selling a stock you already own, and only minor costs to buying one (assuming a boundedly rational person would only buy a stock they’re already paying attention to). So if you don’t sell, or don’t buy, I’m comfortable saying that you’re making a judgment on the value of the stock, just as much as if you do buy or do sell. Along these lines, I’ve always found it curious that the advocates of the marginal-investor theory say that the marginal “buyer” is the one setting the price. There’s obviously someone on the other side of the trade, so why don’t we say it’s the marginal “seller” who’s setting the price? I think the reason is that in the original CAPM, supply is assumed to be fixed and inelastic. But this seems just wrong as a description of how prices are set. I think the demand curve for stocks slopes downward and the supply curve—which in this case represents the shares that existing shareholders will sell—slopes upward. And the curves are aggregate, not individual, I think, the way they are in any one-price market. “Noise” is a very good piece. Shallowly, I like the fact that it’s readable and clear.

By: dsquared

dsquared — Fri, 23 Jan 2004 18:35:41 +0000

James: I would say that if someone is not “literally” making a decision, then they’re not “effectively” making it, when the context is buying and selling. It’s not that you don’t have a point, it’s just that the point is dependent on a sense of “cause” which is just too rarified. As far as I can see, one could argue analogously to your above that the people of Iraq were responsible for keeping Saddam Hussein in power by “not rebelling”. Which in a sense they were, but not one which ought to gain any traction. Furthermore, does this mean that people with no holdings of stock at all are helping to set the price by “not buying”? How about people with no wealth at all who exercise the choice not to take out a bank loan or sell their house to buy stock? It strikes me that as yet undiscovered Amazon Indians might be part of the price discovery process on this basis. Have you read Fischer Black on “Noise”, by the way? Not that it’s relevant to this point, but it’s a good piece.

By: Sebastian Holsclaw

Sebastian Holsclaw — Fri, 23 Jan 2004 17:07:52 +0000

And that suggests to me that in most cases people don’t know what they know and, just as important, don’t know what they don’t know (acknowledging, of course, that putting all your money into one stock, no matter how certain you were of it, would not be a sound investment strategy). Which brings us back to the market. Individuals don’t know enough about lots of things. But collectively The People do know enough and signal all sorts of knowledge through the markets.

By: James Surowiecki

James Surowiecki — Fri, 23 Jan 2004 07:50:51 +0000

The point about the investors who know everything about one stock and nothing about 499 is a good one. But that’s what’s interesting, that people don’t invest only in the stocks that they really have superior information about(otherwise more money managers would outperform the market). And that suggests to me that in most cases people don’t know what they know and, just as important, don’t know what they don’t know (acknowledging, of course, that putting all your money into one stock, no matter how certain you were of it, would not be a sound investment strategy).

By: andrew

andrew — Fri, 23 Jan 2004 07:49:23 +0000

I wonder how the shifts in the candidates’ prices after the first primary compare to shifts in stock prices after earnings reports.

By: James Surowiecki

James Surowiecki — Fri, 23 Jan 2004 07:45:33 +0000

The “marginal buyer” theory is the classic explanation for how the informed 10% set the price. But I think the idea of the marginal investor is just wrong. Prices are set not just by buying and selling, but also by not buying and not selling. If the price of a stock I—an uninformed investor—own rises on smart sharks’ buying and I don’t sell, my not selling is setting the new price as much as the shark’s buying did, because it’s only my decision (and that of all the other shareholders) to “not sell” that keeps the price at its new level. Of course, someone is always setting the price on the margin in a purely functional sense, but unless they have enough capital to outweigh the buying (or selling) power of all other investors, they cannot, in any sense, determine the price of the asset. There are no intra-marginal investors in an asset (aside from those who are legally prohibited from selling), because at every moment (not literally, but effectively) an investor is deciding whether to sell or not-sell the assets he owns, and those decisions are as determinative of the price of the asset as any others. (I cribbed all that from something I wrote on Brad DeLong’s site, because even if it’s wrong I can’t be any clearer in my wrongness.)

By: dsquared

dsquared — Fri, 23 Jan 2004 07:19:41 +0000

How — in a literal, mathematical sense — can the 10% be the ones who are dictating the price? Under classic market microstructure theory (as in Maureen O’Hara’s excellent book of that title), the answer to this si that the price is set by the marginal buyer, not the average. Informed investors might be a small minority of the total number of shares outstanding, but they could easily be a majority of any given day’s trading volume in companies which are on the move. Also note that it is entirely possible to have a market in which 100% of investors are basically stupid about 499 stocks in the S&P500 but know everything there is to know about one stock. That’s actually closer to Hayek#s idae of local, tacit knowledge.

By: James Surowiecki

James Surowiecki — Fri, 23 Jan 2004 04:34:53 +0000

With regard to the second point, I think our ideas of where the “systematic distortion” comes from are different, which leads to our differenct conclusions about the possible usefulness of an internal market. I don’t think that mistakes in most organizations are induced by explicit, top-down policies that are meant to silence dissent. I think instead they’re the result of people’s relationships with their department heads, or their division heads, or their fellow VPs, etc., relationships that end up encouraging compromise and going along to get along rather than honest thinking. That’s not the result, in my mind, of malevolence, but rather of the nature of most bureaucracies. So the reprisal I’m talking about isn’t a system-wide reprisal—with, say, the White House punishing agents who speak out of turn—but rather the day-to-day punishments inflicted by immediate superiors worried about covering their asses. The virtue of an internal market is that none of that stuff matters. No individual is responsible for the market’s final verdict—both because the traders would be anonymous and because a market price is a collective judgment—so no one can get blamed for it. I think that would help. I also think, more practically, that an internal market is very useful in cases where organizations are divided into silos, as the U.S. intelligence community has traditionally been. Again, the division is not the product of malevolence, but it’s clear that there was much less intelligence-sharing going on than there should have been because agencies saw other agencies as rivals. Cultural identity, in a sense, trumped the collective goal of getting good intelligence. In an internal market, people would be rewarded for the accuracy of their predictions. I assume, in that case, the desire to be right would trump cultural identity. And again, since no one agency would be given credit for the final judgment, no agency would have an interest in subverting it. There’s no doubt, of course, that people higher up the food chain might shut down such a market as soon as it produced judgments they didn’t like. But as I said, I do think in the end most leaders want their picture of their world to reflect the reality of the world, and so if the market proved relatively accurate (that is, better than other mechanisms) I think they would keep using it.

By: James Surowiecki

James Surowiecki — Fri, 23 Jan 2004 04:21:27 +0000

Michael, with regard to the first point, my caveat about the internal markets was intended to suggest that an aggregative mechanism that tried to tap the knowledge of people with classified information or direct contact with informants (of the kind I assume some intelligence agents have) might be of use in forecasting impending events. “Forecast” is a deliberately vague word, as is the question I chose as an example. Saying that the collective judgment of a group of CIA analysts and agents might offer some useful information about the likelihood of a terrorist attack in the next 12 months doesn’t mean that group would be able to say “the attack will take place on September 11.” Hoping for that kind of fine-grained result is futile. But if the collective verdict was that there was an 80% chance, that would probably be worth paying attention to in how you directed your intelligence-gathering and homeland-security efforts, and the same would be true if the verdict was that there was a 20% chance. To argue, as you seem to be, that there’s no possibility of such a verdict being accurate is essentially the same as saying that intelligence-gathering is of no use in predicting future events unless the intelligence is of a direct nature (that is, someone says: “X are planning to bomb the cathedral on this date”). That may be right, but I don’t believe it. I suspect that there are small pieces of information that analysts and agents come across every day that individually are not probative, but that if they could be aggregated might be meaningful. An internal market would be one way of doing that (though I also think there are other aggregative mechanisms that could work as well).

By: Michael Pollak

Michael Pollak — Fri, 23 Jan 2004 02:12:56 +0000

James, you say: As to whether it could have worked, I guess I see the political and bureaucratic hurdles that need to be circumvented differently than you do, Michael. For the most part, I don’t think you get bad decisions and predictions within corporations or governments because of conscious malevolence or manipulation. But on the contrary—that seems to be exactly what you’re presuming: In a sense, I think the true “consensus” view (I’d say “collective” rather than “consensus,” but no matter) will often not emerge unless there’s a mechanism that allows pepole to express what they really think without fear of reprisal. An internal market is one possible way around that. Unless I’m misreading you, “fear of reprisal” is exactly the precondition that makes such a market useful. If there is no fear or reprisal (in the broadest sense of reprisal) or other systematic distortion, than there is nothing for the market to remedy—because in that case, the collective view will already be emerging more directly through people telling each other what they think and defending their opinions with reasons. And that leads to my dilemma. If there is systematic distortion, I don’t see why it shouldn’t distort the results of the market (that is, lead to them being ignored or explained away). And if there’s no systematic distortion, then there’s no need to set such a market up because a clearer version of the collective view is already on tap.

By: Michael Pollak

Michael Pollak — Fri, 23 Jan 2004 01:50:27 +0000

James, you say: The internal markets, from what little information I’ve been able to glean about them, might have dealt with more specific questions, although even there I imagine the questions would have been relatively broad (perhaps, and I’m just guessing, something like, “What are the chances of a major terrorist attack on U.S. soil in the next 12 months?”) But I thought you had agreed that this was precisely the sort of prediction such markets couldn’t make: I agree with [Michael] that markets — or any aggregative mechanism — have little chance of predicting an event that no one (or only a tiny number of people) knows is going to occur (like, say, a terrorist attack). And yet now you seem to be suggesting this idea has value. Did I miss a step?

By: James Surowiecki

James Surowiecki — Thu, 22 Jan 2004 23:06:48 +0000

I would think people have better private information about the chances of political candidates than about most things. Their private information would be based on conversations with family and friends, their experience of the current economy, the way their business is going, their sense of how people are reacting to news from Iraq, etc.: all the myriad small things that collectively end up determining election outcomes.

By: James Surowiecki

James Surowiecki — Thu, 22 Jan 2004 23:03:44 +0000

I think there’s no evidence—experimental, theoretical, or empirical—that people who are right have a better sense of whether they’re correct or not than people who are wrong. To put it more formally, in all of the studies I have seen, there is only a small correlation between a person’s skill level and his confidence in his own skill (assuming, for argument’s sake, that there are people who are individually more skilled at predicting the future than others). People bet and invest when they’re wrong because they think they’re right. If there are a lot more people who are, in aggregate, wrong than right, their bad judgment will swamp the good judgment of the intelligent. This doesn’t mean that smart people don’t matter. They can significantly improve the “group’s” judgment. But they can’t make a difference if most people’s collective judgment is radically off-base. Take the stock market. We know that in any given year most fund managers underperform the market, and that over a typical 15-year stretch only something like 1-in-10 managers beat the market. The 90% of the managers who are “dumb” command vastly more capital than the 10% who are smart, and they’re deploying it left and right. How—in a literal, mathematical sense—can the 10% be the ones who are dictating the price?

By: John S

John S — Thu, 22 Jan 2004 22:36:08 +0000

Thanks for that clarification James. Still, it takes me back to my original question about the IEM. Is it really a good test of the predictive power of markets? After all, what private information do people have that they can reveal to IEM about the nomination chances of each of the democratic candidates? Also, when you write “Certainly in this case markets can work well (as long as the ignorant people are making choices that collectively average out to something close to what the people who know a lot know, because otherwise the ignorance of the many would swamp the intelligence of the few).” it puts me in mind of the Guys and Dolls discussion of betting. Why would someone who knows nothing bet much? That’s the point of futures markets surely? If you know a lot, then you’ll bet and that’ll show up. Why would the ignorance of the many swamp the intelligence of the few? These futures markets should give more weight to those who “know” most.

By: James Surowiecki

James Surowiecki — Thu, 22 Jan 2004 21:07:06 +0000

To me, “asymmetric information” implies a situation in which a few people know a lot and most people know little or nothing. Certainly in this case markets can work well (as long as the ignorant people are making choices that collectively average out to something close to what the people who know a lot know, because otherwise the ignorance of the many would swamp the intelligence of the few). But you can also imagine a situation in which people’s knowledge is spread out on a spectrum (or along a bell curve), so that lots of people know something relevant about a question, even if no one person knows everything. In that case, getting people to reveal their private information (and “information” in my usage is a capacious term, including analysis, etc.) would still be essential to getting a correct forecast, even though the information distribution wouldn’t be “asymmetric” in your sense of the word. (Just as a side note, “asymmetric information” is probably not the best phrase for what you’re describing, since in the economics literature asymmetric information is traditionally used to describe situations where one participant in a potential contract knows signficantly more than the other (like, say, when you’re buying a used car). In many of those situations, asymmetric information leads to market failure.)