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The rise of collective intelligence started with 800 farmers in Britain successfully estimating the weight of cow at a country fair. And through centuries it has risen in importance; as one inclined toward technology, I could argue that Wikipedia represents the pinnacle of collective intelligence: a crowd-sourced Library of Alexandria that is more accurate than the encyclopedias of Britannica and Grolier. More broadly, however, the most important applications of collective intelligence are the stock markets where trillions of dollars of wealth are created and destroyed.

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In the market, the public uses collective intelligence to create yardsticks to measure the value of a particular asset (company).  Over the years, we’ve created ever more esoteric representations of goods starting with equities (shares of ownership in a corporation), bonds (shares of debt that belongs to a corporation), swaps (the simultaneous sale and purchase of the same amount of a given currency at a forward exchange rate), options (the right to buy equities at a given price at a later date) and so on.

As the banks develop more esoteric “risk-reducing instruments”, in parallel more and more of the public participates in the markets. Pension plans used to manage retirement funds on our behalf. Today, we’re responsible for “responsible investing”. In fact the reason that the US savings rate has plummeted in the past 50 years is instead of putting money into savings accounts, Americans are investing in home ownership and the stock market.

With that responsibility, however, for most there is very little education in the right ways to invest. But invest we have and in so doing, the collective intelligence of the market, which was constituted of expert traders, is diluted.

“Hot stocks” were hawked to newbies looking to make it rich and swarms of investors followed. Banks developed new instruments that doubled return but halved risks and we bought because our brokers and ratings agencies advised us these were good investments. When in the recent booms our hubris convinced us we were smarter than our brokers and didn’t need their experience or their fees,  Etrade, ScottTrade, Ameritrade enabled us to buy stocks directly.

Given this flood of inexperience in the market, how can we expect that the price of a share of equity or a credit-default swap be accurate when so many of the investors in the market aren’t properly educated? 800 farmers correctly guessed the weight of a cow because they had grown up with cows, had raised them, milked them, killed them and eaten them. They were experts in all things bovine. But too few of the investing public have too little experience, insight, information to make any kinds of reasonable estimates about the actual price of an equity.

Multiply that inexperience with the complexity of derivatives and nothing but a train wreck could emerge. The collision of collective intelligence which perceives itself more skilled than it is and salesman eager to make commissions on instruments so complicated, even the experts who created them didn’t understand their implicit worth, could only result in markets whose prices are so skewed a 40% correction is in order.

The SEC was started to protect the small investor. One of the requirements that arose from this organization was the requirement that brokers pass tests to ensure they’re competent to trade in equities and derivatives. Maybe the SEC should require similar tests for individual investors as well.

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