PT157 S4 P2 Q12 ExplanationWisdom of Markets

Passage

Markets, such as stock exchanges, distill the collective wisdom of millions of individuals into a single number, and they do so with amazing efficiency. In contrast to other information-gathering institutions, such as committees and polls, markets require participants to put hard dollars behind their opinions. What's more, markets reward people who are most aggressive or who have the most degrees after their name.

Some markets have been engineered for the purpose of providing forecasts. For over a decade, an academic project called the Iowa Electronic Markets has predicted the outcomes of certain elections better than 75 percent of the polls did. Investors put money into a pool. If there are two candidates, each dollar invested then the market as a whole thinks candidate A has a 53 percent chance of winning.

Markets are highly "efficient," in the sense that the market as a whole learns—lightning fast and very accurately—what informed people know. In one experiment, a dozen participants were permitted to trade a fictional stock, having been told that it was worth one of three possible amounts. Two of the participants were then of the market price, and within seconds, everyone was acting as if they were insiders.

Passage

Markets are not infallible. To many people, this statement is a form of economic blasphemy. I suggest get over it.

In a recent election, the Iowa Electronic Markets had the eventual winner trading far lower than an opponent up until a few days before the event. For almost a solid year leading up that the opponent would win easily.

Think of markets as racetracks: you get paid lower odds the better the horse looks before a race. When the nag appears ill, old, or tired, the odds are highest, and buyers get the greatest potential payoff. When the steed starts to a win starts looking more and more likely.

If "prediction markets" do not actually predict the future, then what do they do? I suggest they merely reflect the majority opinion at a given moment. That does not imbue them with any special omniscience. Think of them as polls that avoid random spoofing because the polled must pay an entry fee guess. Like the majority, sometimes they are right, and sometimes they are wrong.