Collective intelligence web technology

Collective intelligence web technology is a new technology in the web space. Gartner rated this technology as transformational Web 2.0 technology. Collective intelligence enables new ways of doing business across industries that will result in major shifts in industry dynamics. It is expected that the CI web technology to reach mainstream adoption in five to ten years. Collective intelligence is an approach to producing intellectual content (such as code, documents, indexing and decisions) that results from individuals working together with no centralized authority. This is seen as a more cost-efficient way of producing content, metadata, software and certain services.

Business opportunities of Collective Intelligence

I first encountered the collective intelligence a few years ago when Max introduced the book “Wisdom of the Crowds” to the stock-poll group. Since then, I have thought that there are many success stories about the wisdom of the crowds. One of the examples is the Linux project and its associated open-source software development. Another example is the Wikipedia. Its success is beyond imagination. Now Wikipedia is probably one of the best encyclopedias in the world.

A Business Week story about Digg.com strokes me so deep that I feel that I have to do something about this emerging technology. The power of collective intelligence combined with the Internet connected with diverse individuals is the potential to do great goods to the society.

I talked with Zhao Zhen about my thinking. I think we should combine this collective intelligence web technology with our current thinking about optimal investment portfolio based on historic data. If the two methodologies can be fused together we could create a superb technology for intelligent investments. Yesterday we met again at Starbucks and talked more about this new endeavor. We have arrived at the following basic three-part model.

We will define our space as three independent parts --- Investment Securities, Information Sources, and Evaluation Agents.

The investment securities are all investment vehicles available to individual investors, including mutual funds, closed-end funds, exchange-trade funds, individual stocks, and bonds. For each investment vehicle, we will calculate its investment merit points. We expect to associate the investment merit points with investment potential gains. The higher investment merit points should mean higher investment potential gains. Each investment vehicle will be assigned a total merit based on the evaluation agent’s multiplying factor and the credit-worthiness of the information sources used.

The second part is the information sources. We currently can think of the information sources as the basic building blocks to form intelligent decisions for individual agents. Some of the investment sources including (1) mass media such as news paper like the Wall Street Journal and magazine like Business Week, (2) academic studies such as investment theories recognized by Nobel price or accepted by the practicing industries, (3) Fund managers such as those who have established proven records like Warren Buffett and Peter Lynch, (4) brokerage analyst reports, (5) government statistics reports, (6) Fund management companies such as Vanguard and Fidelity, and (7) new information sources generated by the evaluation agents. Each information source will be assigned credit-worthiness scores given by the evaluation agents. The credit-worthiness scores of information sources will be determined by its independence and originality.

Charlie has established a guru focus website. He has indicated that the website has attracted many visitors. This website has only listed about 30 plus value investors. In the fund managers information source category we will have many sub-categories. Besides value investors, we can have growth investors, balanced investors, commodities investors, real estate investors, etc.

The third part is the evaluation agents. Each agent can work independently or cooperatively on recommending or evaluating any investment vehicles based on available information sources. Each agent will evaluate each investment vehicle with a buy/sell/neutral rating. A multiplying factor is used to carry the different weights of different evaluation agents. The multiplying factor weight is determined by the evaluation agent’s past performance of recommendations and power points given by other evaluation agents.

What is Collective Intelligence?

Collective intelligence is a human enterprise. I first recognized it in the early 1990s when I was thinking about the societal brain and societal body. I was thinking that the Internet was the backbone for the new societal brain to develop. It is paramount for people who believe in collective intelligence who have the mind-sets and willingness to share, and openness to the value of distributed intelligence for the common good of the society. Individuals who respect collective intelligence are confident of their own abilities and recognize that the whole is indeed greater than the sum of any individual parts.

In order to really utilizing or maximizing collective intelligence, an enterprise should strive to avoid groupthink. Groupthink is the tendency of all individuals in a group to think the same way.

Intrinsic + Fashion + Exuberance Values

In my study of tides, there are higher high, lower low, higher low, and lower high. You stock guys use similar words like people studying tides.

Tides are usually controlled by two forces: gravity of the Moon and that of the Sun. Since the two forces are not exactly aligned with each other, so the combinations of high & low appear. When the Sun and the Moon are on the same side, higher high and lower low are created.

I assume the stock markets are controlled by more than two forces (let's assume there are N forces), so there must be N^2 combinations of high and lows. Since the number of combinations increases proportionally to the square of the number of factors, it will become difficult to estimate the impact of each factor.

A friend of mine who studied the market using factors analysis, he concluded around 1998 that there are three independent factors control the market. In this case, N = 3. So we would have 9 combinations of high-mid-low.

Following this line of logic, I proposed three controlling factors which may contribute the market movements and volatility.

(1) Economic factor is the number one factor. Since Economics is the scientific study of the economy, so anything that is covered under the big title of Economics may contribute to the stock market movements. These factors include the supply-demand mechanism as you mentioned. One is likely to invest in the stock market because I think I know economics.

(2) Psychological factor is the second factor. One of the reasons many people participate in the stock investment is the fear of loosing out the potential opportunities. One might invest without any real understandings of the economics behind the stock market. Many psychological factors such as greed and fear are good examples of psychological factors.

(3) Societal factor is the third factor. Another reason to market changes is that of the society. One might invest in stocks because she or he has a fried who has given him/her a good tip about some stocks. There are many social factors which may contribute to driving people into investments. Examples of social factors are mass media, families, friends, coworkers, etc.

So overall, the economic value of stocks is the real intrinsic value of the stock. The societal value of the stock is like the fashion value. The psychological value of stock is the exuberance value. So I propose a three-factor model for stock values:

Stock Price = Economic Value + Societal Value + Psychological Value

Or alternatively,

Stock Price = Intrinsic Value + Fashion Value + Exuberance Value

Any stock analysis should be able to decompose stock prices into three sub-values so that one can judge the real value of the stock.

Since the economic or intrinsic value is the most stable value, it will not change frequently over time. Value investors are mostly concerned with estimating the intrinsic value of stocks. The Societal or fashion value can come and go just like fashion in consumer products. The so-called sector rotation funds are established based on the movements of fashion among different industry sectors. The psychological or exuberance value is the direct results of the crowd. To me it is the most unstable value to account for. Many trading methods are the most direct applications of psychological factors.

The Institutions-Individuals Pair

In my previous blogs I had discussed about the societal beings (societal body and societal brain). I was thinking about the Internet was the backbone for super-human-beings. After reading an article about Digg.com where news articles are rated by the netizens, I suddenly realized that the super-human-beings have already existed in our society. Institutions are such super human beings. Stock markets are such super beings.

There are millions participants of the stock markets – they buy or sell stocks every day. Each stock player does not have a complete picture of the market while the market is entirely determined by the sum of all stock players. In this societal body and societal brain pair, the individual stock players are just like the cells in our human body while the stock markets are just like the human beings themselves.

It is a great day for me to realize such a paired structure among human beings and the institutions we collectively created. This new realization will guide me in thinking about the future of how institutions are developed and advanced.

I was thinking about the Internet as the backbone for building such pairs between human beings and super-beings. Now there are no such super-beings. There are just institutions we developed over our history. The Internet helps formalizing the virtual networks of institutions. Before the Internet, all institutions are connected by discrete objects such as books, news papers, legal documents, etc. Now with the Internet, institutions can have continuous structure among them.

Along this line, I have to think more about how human beings can understand institutions and nurture new institutions. I will study the market institutions first. There are stock markets, international currency markets, bond markets, options & futures markets, and commodities markets. All these markets are example of institutions. The same institution-individual pair relationship exists. Now I can see a new branch of sociology – the networked institutions.

Why is high risk related with high return?

The current theory about the risky asset returns is that the investment return is proportionally related to the volatility of the investment. In a mathematical form, this relationship can be expressed by the equation.

μ = θ + K σ

Where K is a constant, θ is risk-free return, σ is standard deviation, and μ is the expected return.

The question is why the expected return of risky asset is related to the risk level (standard deviation). Higher risk means higher return. Where does the additional level come from? What is the physical model behind this mathematical equation? Today I think I have solved this physical model problem. This is related to the years of trading experience and my thinking as a hydraulic engineer.

Suppose UBC (uniform building code) is the bible for civil engineers, every practicing civil engineer would buy a copy of UBC at some standard price. Now suppose that the software engineers predict that UBC would be a popular reference book for electronic engineers, chemical engineers, and mechanical engineers. The soft engineers would buy many copies of UBC in order to sell the books later at higher price. So the software engineers would make a profit due to this speculation. The software engineers did that, then the electronic engineers did that, then the chemical engineers did that, and so on. So the demand for UBC is indeed up, so does the book price. After a while, all other engineers except civil engineers realized that the UBC is indeed useless for them. So they are going to sell the acquired books. Then the book price would drop. I think in the stock market, the civil engineers are like the long-term investors (they buy the books for the intrinsic value of the books) while other engineers are the traders (they buy the books because they think they can sell the books at higher prices). So the price of UBC would fluctuate around some intrinsic price.

What to Consider before each trade?

Peng Youhang gives us some great insights. This is a great list of questions to consider before each trade. Here are my opinions about each question.

1. How much do you bet on this view (in percentage of your investment capital)?

I believe one should invest consistently with his or her view. It is too hard for me to do it in any other ways. Like the volatility of the market, our thinking has a lot of noises, too. One should not confuse the thinking noises with the true and consistent thoughts. In other words, the thinking noises are highly correlated with the market volatility. The true and consistent thinking should have a low correlation with the market volatility. Recognizing our thinking has Mu and Sigma is one of the most critical steps in trading/investing.

2. What is the probability of your view being right? (of course one can never be sure)

In the United States, one common statistical number is the percentage of divorce rate (approximately 50%). Marriage is a serious thing, at least as serious as investing. Our thinking has a high probability of being wrong or reversed over a period of time. Some times the period of time can be very short. I view my betting probability of being right is roughly 50%. So not loosing much when the right bets turn out being wrong is also critical in investing/trading.

3. What is your stop-loss point? At what point, you have to cut loss and cover? (Even though you may still believe your view is right but you must cut loss to ensure survival).

I do not have a stock-loss per se. However, I believe in another principle of allocating capital among risk-free asset and risky asset. There are two basic principles to me. One is related to sell and another one is related to buy. No matter how high the market is going, you have enough shares to sell if you want to sell. No matter how low the market is going, you have enough cash to buy if you want to. If one can do both for a long time, I believe one would have a totally different view about the market and investing.

4. At what point, do you think you may be totally wrong in your actions and should consider going the opposite way?

At all cost, one should avoid the situation of this condition. One should anticipate these at all times. The goal should be not loosing money. Making money should be just a consequence of not loosing money. Going the opposite way should not happen at all.

5. What is your profit-taking point? Do you increase your position at some point?

Profit-taking or increasing positions should be determined long before the actions are taken. Profit-taking or increasing positions should be default action of some trading/investment strategy, not an ad hoc or impromptu action at the point. The entire art of investing/trading rests on the mastering of this balance.