Systematic Relative Strength

NPR, reporting on “The Good Judgement Project” writes a fascinating story about the wisdom of crowds. Maybe there is something to this momentum factor after all!

For the past three years, Rich and 3,000 other average people have been quietly making probability estimates about everything from Venezuelan gas subsidies to North Korean politics as part of the Good Judgment Project, an experiment put together by three well-known psychologists and some people inside the intelligence community.

According to one report, the predictions made by the Good Judgment Project are often better even than intelligence analysts with access to classified information, and many of the people involved in the project have been astonished by its success at making accurate predictions…

…How can that be?

“Everyone has been surprised by these outcomes,” said Philip Tetlock, one of the three psychologists who came up with the idea for the Good Judgment Project. The other two are Barbara Mellers and Don Moore.

For most of his professional career, Tetlock studied the problems associated with expert decision making. His book Expert Political Judgment is considered a classic, and almost everyone in the business of thinking about judgment speaks of it with unqualified awe.

All of his studies brought Tetlock to at least two important conclusions.

First, if you want people to get better at making predictions, you need to keep score of how accurate their predictions turn out to be, so they have concrete feedback.

But also, if you take a large crowd of different people with access to different information and pool their predictions, you will be in much better shape than if you rely on a single very smart person, or even a small group of very smart people.

“The wisdom of crowds is a very important part of this project, and it’s an important driver of accuracy,” Tetlock said.

The wisdom of crowds is a concept first discovered by the British statistician Francis Galton in 1906.

Galton was at a fair where about 800 people had tried to guess the weight of a dead ox in a competition. After the prize was awarded, Galton collected all the guesses so he could figure out how far off the mark the average guess was.

It turned out that most of the guesses were really bad — way too high or way too low. But when Galton averaged them together, he was shocked:

The dead ox weighed 1,198 pounds. The crowd’s average: 1,197.

My emphasis added. As pointed out by Philip Tetlock, “everyone has been surprised by these outcomes.” Just like everyone (or many) are surprised by the results of momentum investing. Yet, momentum works for for the very same reasons that “The Good Judgement Project” is apparently succeeding—the wisdom of the crowds. It requires a certain amount of humility to turn investment decision-making over to the wisdom of the crowds and humility is not an attribute in great supply on Wall Street. The vast majority of investment managers in this industry spend large portions of their time convincing others (and themselves) that they are right and “the market” is wrong, but that the market will eventually come around to their way of thinking. Momentum takes a different approach. If a given security, or group of securities, are relatively stronger than their peers momentum investors follow those trends—often times without a clear understanding of the fundamental reasons for the superior momentum characteristics. If the market changes, momentum investors change and reorient their portfolios to adapt to the new leadership. Momentum investors focus on the process of keeping their portfolios in-tune with market trends rather than praying that the market will eventually prove that any one “expert” opinion will prove correct.