Monday, January 2, 2012

The Wisdom/Madness of Crowds: Obama, Hillary, New Hampshire, and Me

One of the “pop economy” ideas now in vogue is the wisdom of crowds. It is often invoked as the theoretical foundation of crowdsourcing. The idea in its current incarnation is not all that new and has some very respectable origins in economic theory. It can go as far back as Adam Smith’s invisible hand. Much of modern economics is fascinated with complex (social, economic, online) systems that function without centralized organization. Capitalism is one such system… up to a point (leaderless movements such as Occupy Wall Street or the Spanish indignados ironically imitate markets in their attempts to create non-hierarchical modes of organization). Milton Friedman’s classic example of the pencil is one point in case: thousands of people spread all over the world collaborate to obtain the wood, graphite and rubber to make the humble pencil, but none of these people know each other and no unified, central authority coordinates their work. There are no über-project managers coordinating all this movement to and fro of goods and services. No, the massive organizations that work together to build a simple pencil do so in the absence of a central planner.

One recent application of this idea is the fad for prediction markets. You can go to InTrade and make a bet on a mesmerizing variety of world events. Do you think Ahmadinejad will be ousted as Iranian president by December 31? You can make that bet there. Do you think Sarah Palin will jump into the Republican race? Ditto. It is a corollary of the efficient markets theory. According to this very influential current of thinking, one single individual cannot know what will happen in the future. But if a market is large enough and liquid enough and fair enough, those markets (which, remember, are the aggregation of choices made by thousands or millions of investors) are powerful indicators of the future. The same principle underlies our interpretation of bond markets: the variation of U.S. Treasury yields can be taken as a proxy for what investors think about the medium-term future of the economy.

I became a punter at InTrade during the 2008 U.S. presidential elections. And I had a really bizarre experience that taught me a lot about the value of the wisdom of crowds.

I was determined just to make small bets (and InTrade does allow you to make tiny, tiny bets because trading commissions are very low). I can’t have wagered more than $30 or $40 in tiny bets of a dollar or so. I don’t remember exactly what my strategy was: whether betting against conventional wisdom or making small bets on unlikely outcomes. But it was something along those lines. Anyway, in January 2008, as primary season (four years ago exactly) was revving up, I probably had ten or so bets on the first few Democratic and Republican primary races. Then I just lost interest. In InTrade. Not the election itself.

First of all, if you recall, Obama won the first primary in Iowa. Against all odds, a black man won in Iowa! I distinctly remember his victory speech. I had heard all the buzz about Obama, but I had never actually seen him speak. Then he got up on that podium. His posture was strange. He didn’t look straight at the audience. He just sort of looked askance at some point in front of him. He wasn’t at all euphoric. He was incredibly calm. He lifted up his hand and said, with that intonation: “They said this day would never come…” I literally felt chills. I had never seen anything like that. I had read about similar speeches. I had seen the tape of Bobby Kennedy speaking on the night Martin Luther King was shot. I have read Lincoln’s speeches. I read a book on Miguel de Unamuno’s “venceréis, pero no convenceréis”. But to actually see a performance like that live was totally different.

Anyway, Obama’s victory in Iowa probably blew all my bets to hell. I just lost interest in the InTrade game and got swept up in the media-driven soap opera of the campaign. The conventional wisdom that the race was Hillary’s to lose immediately shifted after Obama’s upset. Whereas, before Iowa, Hillary only needed to tap dance her way to the nomination, she was now written off. Completely. Obama was crowned as the certain Democratic candidate. Hillary was yesterday’s news. Maybe you don’t remember the events of that amazing week. I remember checking my InTrade markets. Effectively, the market was now giving Obama an above 90% chance of winning in New Hampshire, the second primary, usually held one week after Iowa.

The thing is I got bored with my bets and did not change them. And here is the key detail: I had a bet on Hillary winning in New Hampshire. Not that I actually thought she would win. It was just that I was so uninterested in the game, I left an old bet on. And then something amazing happened. You must remember it. Hillary Clinton made a campaign stop in which she sat down to speak to a group of women in New Hampshire. It was the usual political rhetoric, but the strain was visible. Clinton made remarks about what a mistake the electorate was making by choosing the wrong person (many pundits honestly thought Obama was unelectable). And then someone asked her how she was holding up. And then the most amazing thing happened. Her voice cracked. “It’s hard,” she managed to say and then her eyes welled up. The world watched in wonderment: “Oh my God, she was showing some real emotion! Hillary Clinton is a human being!” I can’t say I ever liked her, but it was a real moment. You felt all that she was feeling. All that work, all those years of being the perfect student, the Stepford wife, the good daughter, all the humiliations that led her to that moment and it was slipping away, right when it was in the palm of her hands. How could you not feel some empathy?

So it was a strange, touching TV moment. Even memorable, perhaps, but Mrs. Clinton was still heading for a crushing defeat. All the polls put her well behind Obama. And then something even more amazing happened. I remember following the CNN coverage via the Internet and simultaneously watching my InTrade positions. The first returns, oddly, had Clinton winning by a small margin. Not a strange thing with small percentages and early returns, as any political junkie can tell you. But the InTrade market moved. It trembled the tiniest little bit. Obama’s odds of winning went down from about 90% to about 85%. Hillary was still cruising for a bruising. And, since my bet on Hillary was still on, I started to make a little money on my one-dollar bet.

I won’t drag it out. As return after return rolled in, Hillary Clinton achieved a lead and maintained it against her younger and flashier opponent. Although I liked Obama, it was delicious watching the position on the InTrade screens. With every new percentage announced by the networks, the Obama and Clinton lines got closer and closer and closer, until it was 50-50, and after 60% of the returns were in, the roles were completely inverted. Hillary Clinton was being given a 95% chance to win New Hampshire and Obama only 5%: with 92% of the votes already counted.

My one-dollar bet was now worth about $14. A one time 1300% gain is nothing to sneeze at. And if you’ve ever had one, it feels a little like winning the World Cup. I know now why some people get hooked on gambling. And why traders can get hooked on what they do. Fortunately or unfortunately, I don’t have those genes. I’m not dumb. I recognized what had happened. My indolence in maintaining my old bets had left me exposed to a positive black swan, a nearly impossible chance occurrence which, oddly, happens more often than our misguided theories about statistical probability and the wisdom of crowds would suggest. I simply pocketed my ill-gotten gains and exited the market. Never to return again, nursing an (overall) ten-dollar loss (more or less) and a little bit more (individual) wisdom.

So you ask me if markets are rational? If they can predict the future? If crowds are better at telling the future than an individual?

Well, the InTrade market did predict that Hillary Clinton would win New Hampshire… about two hours after she actually won the state. So there you go.

Miguel Llorens is a freelance financial translator based in Madrid who works from Spanish into English. He is specialized in equity research, economics, accounting, and investment strategy. He has worked as a translator for Goldman Sachs, the US Government's Open Source Center, and H.B.O. International. To contact him, visit his website and write to the address listed there. You can also join his LinkedIn network by visiting the profile or follow him on Twitter.


Jordi Balcells Antón said...

Luckily I had never heard of InTrade. Why 'luckily'?

If many people believe in the wisdom of the crowds and there is a place where this wisdom plays a central role, what would happen if someone where to place an extremely large amount of money on a particular bet? If InTrade was really well-known and its predictions considered relevant, the trends (bets) themselves could affect reality. Thus, someone with a hidden agenda and enough money could have gotten Obama elected in NH just because of the initial bets.

Self-fulfilling prophecies = BAD.

So, it is better not to believe in the wisdom of crowds. We are a little bit freer this way.

Miguel Llorens M. said...

Aha, I am guessing that you read a lot of science fiction? Yes, I had not thought of that. In a world in which prediction markets acquired prediction status, anybody who could "game" the prediction market could (to some degree) "game" the reality that is being predicted. Let's call it the "Minority Report" hypothesis. People who believe in strong version of the efficient markets hypothesis would dismiss that as impossible, but anyone who has seen successful manipulations of very large markets would take that possibility into consideration.