As many people know, and as James Surowiecki chronicled in his famous book, The Wisdom of Crowds, large numbers of ordinary people can often outperform experts. Lately, though, the idea has mushroomed into excessive enthusiasm for crowds.

Terms like open source and crowdsourcing have entered the lexicon and have formed fanatically engaged advocates. There have been impressive successes, like the Firefox internet browser the Apache web server project. However, much like people, crowds can be foolish as well as wise.

The ability to make distinctions between smart and dumb crowds can be the difference between a runaway success and unequivocal disaster.

Crowd Failures

Everybody knows the danger of an angry mob, but the stupidity of crowds is not limited to drunken rabble. Large numbers of highly intelligent people can exhibit behavior that is far more damaging than a few hours of vigorous rock throwing ever could.

Market Failures: From Tulip Mania to the Great Depression to the latest financial crises, markets have a way of getting out of control. During the boom, pundits find highly plausible reasons for the party to go on. New technology, globalization, whatever… Someone is always ready to give an explanation.

Asset values soar, fortunes are made and everybody is a genius. When the inevitable crash comes, pundits (often the very same people) are there again to explain how they knew it all along.

Moreover, the pundits tell us with a solemn and foreboding tone, things can be expected to worsen. Our best days are now forever behind us. Asset prices then become irrationally undervalued, at least until the next boom (which again, many will rush to retroactively predict).

The Millennium Bridge: In 2000, the Millennium Bridge opened in London with great fanfare. However, as soon as people started to walk across it started to sway wildly. What was supposed to have been a great celebration instantly turned into a nightmare.

What had happened was that that, for whatever reason, the bridge rocked a bit and people on the bridge tried to keep their balance. When they did that, they created momentum in the opposite direction. That of course, forced even more people to put their weight on the opposite foot.

On it went, from left to right, right to left. As people moved their weight to keep the balance the bridge continued to sway. The bridge was closed for two years until design modifications could be implemented that would correct for the stupidity of corwds.

The Winners Curse: Auctions often result in overvaluation. The best bid is the highest, not the closest to the actual value of the asset, so irrational behavior is encouraged. That’s the winner’s curse. It is especially prevalent in telecom spectrum auctions and high profile corporate acquisitions.

It seems that the dumbest crowds of all come with advanced degrees.

The Independence Condition

All three examples above have something important in common: interdependence. That’s what creates the feedback that makes a crowd dumb. Although we are individuals, we actually very rarely act independently. We plan our route to work to avoid traffic, try to be a team player at work, tend to watch movies that are popular, etc.

This is actually a very big problem, since virtually all of business statistics are built on the independence assumption of a bell curve. Human behavior is not like a coin flip, what one person does will influence the decision of others. George Soros calls this principle reflexivity, and he has made billions betting against it.

The essential condition of any wise crowd is that it remains truly an aggregation of independent actions. With an increasingly interconnected and codependent world, crowds are likely to get dumber, not smarter. As the stakes grow bigger, the potential repercussions become more even more daunting.

Guidelines for a Wise Crowd

Moderation: The best crowds, such as Wikipedia, Mozilla, etc. are actively moderated. Open source communities generate lots of ideas, but someone is still minding the store.

Install Circuit Breakers: After the stock market crash of 1987, stock exchanges created mechanisms to immediately stop trading if the market drops by a certain percentage. You can read more about circuit breakers here.

If you want to keep a crowd wise, protect it from its own stupidity. You need to have a plan to disrupt deleterious feedback loops.

Good Sense: If everybody else jumps off the Brooklyn Bridge, it doesn’t mean you have to. We usually know when the crowd is doing something stupid. Watch out for phases like, “It’ll be different this time” or “This is a new era” or (especially) “it’s a once in a lifetime opportunity.”

There is nothing magical about crowds, except they have the potential to absolve us of responsibility. Many who are jumping on the crowdsourcing bandwagon do so not independently, but by running with the crowd.

And the crowd is always something to bet against.

Greg Satell is a blogger and a consultant at the Americal online media Digital Tonto. You can read his blog entries at http://www.digitaltonto.com