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GameStop, Reddit and the 'Wisdom of Crowds'


On Wall Street, “the wisdom of crowds” refers to the theory that large groups of people collectively are smarter than any individual expert when it comes to things like forecasting where stocks are headed.

But, as the frenzy around

GameStop Corp.


GME 19.20%

trading has shown, crowds also can become mobs—irrational or the opposite of wise.

In his 2004 book “The Wisdom of Crowds,” James Surowiecki uses the example of people at a fairground collectively guessing the weight of an ox. The average of the guesses is closer to the weight than any individual entry. Put simply, the crowd is wiser than any individual.

A similar phenomenon takes place on Wall Street ahead of company earnings reports. When investors expect a company to report higher profits, they tend to bid up the price of its stock well in advance of the official announcement. This happened recently with some tech companies that reported bumper results, says

Art Hogan,

chief market strategist at National Securities Corp.

Apple Inc.


AAPL -0.31%

and

Microsoft Corp.


MSFT 0.08%

had returns of 20% and 12%, respectively, over the three months through Feb. 4, with most of those gains coming long before the companies actually announced earnings, according to data from

Morningstar.

“Those terrific results were getting priced into the market” by the crowd well ahead of time, Mr. Hogan says.

As with the ox example, the crowd or herd of investors forecast strong profits at both companies. This idea is at the center of the efficient-market hypothesis, which says that asset prices quickly anticipate relevant information.

While a crowd’s wisdom is demonstrated frequently on Wall Street, sometimes it appears not to work. Take the recent case of GameStop, which despite being unprofitable shot up to a value of $23 billion, according to MacroTrends; that’s larger than many companies in the S&P 500.

That valuation was caused by a large number of small investors working in concert to drive up the price and force investors who were betting the stock would decline to exit their trades.

“It is irrational that something that barely makes a penny nor two could be driven to such a high price,” says

Jack Ablin,

founding partner at wealth-management company Cresset Capital in Chicago. “I still believe that the price does not reflect the reality of the company.”

The problem with the wisdom of crowds comes down to the reliance of people on averages, says

Steve Hanke,

professor of applied economics at Johns Hopkins University. In other words, the individuals in crowds can come up with wide or narrow distributions of forecasts, with the latter being far more useful for investors. But herding can make the distributions wider, researchers have found, and therefore not as useful. “If you have financial assets and herding then you can easily have very wide distributions, and the wisdom of crowds doesn’t hold,” he says.

“This gets to my major point; the fatal error of averages, which means you should never use an average without looking at the distribution of the data,” Mr. Hanke says.

Mr. Constable is a writer in Edinburgh, Scotland. He can be reached at reports@wsj.com.

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