Tuesday, January 08, 2008

The Wisdom of Crowds?

Here's something fun. Point your browser to one of the websites at which people can trade "shares" in candidates' likelihood of winning the nomination, the Presidency, above a certain fraction of the Electoral College and so forth. The Iowa Electronic Markets are the best known of these "political markets," but my personal favorite is Intrade because it's the easiest to use. In any event, it's considered a sign of the wisdom of crowds (also the title of an excellent book by James Surowiecki) that these markets more accurately predict the outcomes of the Presidential race than do opinion polls.

Well, it may depend on your time frame. Over on Intrade, shares of Hillary Clinton to get the Democratic nomination were trading at 70 cents (meaning if you paid 70 cents you would earn a dollar if she got the nomination and nothing if she didn't) on January 1st, but as of 10:30 p.m. on January 7th, Clinton shares were down to 28 cents (with a bid/ask spread bringing their real value even lower). This sort of stock price crash seems pretty clearly to have been a reaction to the polls, rather than a leading indicator. Clinton's share price fell precipitously after the Iowa Caucuses, but then fell precipitously again after post-Iowa polls of New Hampshire voters began to show Obama opening and then widening a lead in the Granite State.

Somewhere in that observation about the political markets is a cautionary tale about the herd mentality. The wisdom of crowds works best---as Surowiecki shows---when many people actually know a little bit and their errors are random, so as to cancel one another out. That's why the average guess as to the number of jelly beans in a jar is so frequently better than any actual guess. But political marketplaces are guesses about what other people are likely to do, and as to these, it's not at all clear that errors are randomly distributed. Especially if most "investors" are getting their information from the same sources, any systematic biases in those sources will be reproduced in the investors' wisdom.

If this all seems like an esoteric amusement, it's worth recalling that serious academic and real-world proposals are afoot for important government decisions to be made using markets of this sort. The idea, despite its guilt by association with John Poindexter, is not inherently crazy, but it has definite limits.

Posted by Mike Dorf