Monday, June 27, 2016

Brexit and Betting Markets

Over the past few decades many contrarian types have been pushing political betting markets as a way to both predict the future and make important decisions. The idea is that when people are betting their money, they have a big incentive to get it right. So if the market is reflecting a false conventional wisdom, clever people will figure this out and bet against the market until the price reflects this greater cleverness:
Speculative market estimates are not perfect, but such markets seem to do very well when compared to other institutions. For example, racetrack market odds improve on the predictions of racetrack experts, Florida orange juice commodity futures improve on government weather forecasts, betting markets beat opinion polls at predicting U.S. election results, and betting markets consistently beat Hewlett Packard official forecasts at predicting Hewlett Packard printer sales. In general, it is hard to find information that is not embodied in market prices.
On the other hand, polls of the Brexit vote showed it very close, while the betting markets in London had Remain a 10-1 favorite. Seems like a pretty powerful case of market failure.

For an even bigger and more consequential failure, consider the mortgage-backed bond catastrophe of 2008.

I don't think there's any way of getting around the basic fact that financial markets reflect the shared assumptions of people with money. That wisdom may sometimes work better than other decision mechanisms – there is, after all, a whole lot of intelligence spent figuring out how to game these markets – but it still fails on a regular basis.

1 comment:

G. Verloren said...

Humans are generally bad at managing money, even when they think they're good at it.

The motivation of self interest doesn't instantly equate to competance or wisdom in making decisions. Just look at situations like the South Sea Bubble - almost an entire nation of people all pursuing their own self interest bought into the scam.

And why wouldn't you? If you see an opportunity to make a lot of money on a really good deal, your sense of self interest drives you to take advantage of it. That's the problem with self interest - it often works against itself, and often depends on the available information and your own expectations.

If you're convinced the stock market is going to rise, and decide to hold onto your shares, you're acting in your own self interest. If it turns out you were wrong, and prices plummet before you can sell, suddenly you've acted against your self interest. Sure, you had a strong incentive to correctly predict the rise or fall of share prices - but that incentive alone doesn't translate into an increase in accuracy of predictions.

Even the most conservative and careful of investors makes mistakes from time to time, despite the best possible knowledge. And then when you add in the factor of full on betting, which plays much more into quirks of human psychology than into actual rational analysis, the incentive to be right can easily be outweighed by the incentive to take a bigger risk for a bigger potential payout.

So yeah, people are bad at managing money, and even worse at predicting the future, making it a dumb idea to trust the market.