Underpaid Genius

David Leonhardt, When the Crowd Isn’t Wise via NYTimes.com

The rise of prediction markets started in the middle of the last decade, brought about by a combination of politics, psychology and technology. The politics came mostly from the aftermath of the Iraq war, when the collective, pro-invasion opinion of Washington experts came to look tragically wrongheaded. The psychology came from a barrage of research, often called behavioral economics, that created a science of human foibles. People were systematically too confident, the research found. They put too much weight on information they liked and too little on data that contradicted their assumptions.

The only good alternative to a few flawed opinions, some researchers argued, was a vast number of flawed opinions. The biases often canceled one another out. The legitimate information rose to the surface. It was the wisdom of crowds, as the writer James Surowiecki called his 2004 book.

The Internet made collecting the wisdom of crowds vastly easier than before. Intrade, Betfair and other British and Irish betting sites became the public face of prediction markets. Google and other companies started their own internal prediction markets to help them make decisions about where to invest. The Pentagon planned one, to track threats, before deciding it did not like the image of American officials making bets about war and famine.

The early successes of prediction markets were notable. To take a small personal example, my wife and I, not exactly frequent moviegoers, twice won money in a large Oscars pool simply by hewing to the British odds. Much more significantly, Intrade was a more reliable guide to the 2006 midterm election than cable networks. On election night, its odds showed that the Democrats had become the favorites to retake the Senate, while television commentators were still telling viewers it was unlikely.

But the crowd was not everywhere wise. For one thing, many of the betting pools on Intrade and Betfair attract relatively few traders, in part because using them legally is cumbersome. (No, I do not know from experience.) The thinness of these markets can cause them to adjust too slowly to new information.

And there is this: If the circle of people who possess information is small enough — as with the selection of a vice president or pope or, arguably, a decision by the Supreme Court — the crowds may not have much wisdom to impart. “There is a class of markets that I think are basically pointless,” says Justin Wolfers, an economist whose research on prediction markets, much of it with Eric Zitzewitz of Dartmouth, has made him mostly a fan of them. “There is no widely available public information.”

These flaws have become fodder for the markets’ critics. On the day of the health care ruling, the widely read financial writers Barry Ritholtz, Felix Salmon and David Wessel all took to Twitter to point out that Intrade looked bad. Tony Fratto, a former aide to President George W. Bush, noted his “real glee” that “Intrade was wrong, again.”

But such schadenfreude raises a question: once you accept that prediction markets are flawed, do you turn back to the inside experts?

ALAS, the experts’ overall record remains as poor as the behavioral economists maintained — and often worse than the markets’ record. Mutual fund managers, as a class, lose their clients’ money because they do not outperform the market and charge fees for their mediocrity. Sports pundits have a dismal record of predicting games relative to the Las Vegas odds, which are just another market price. As imperfect as prediction markets are in forecasting elections, they have at least as good a recent record as polls. Or consider the housing bubble: both the market and most experts missed it.

The answer, I think, is to take the best of what both experts and markets have to offer, realizing that the combination of the two offers a better window onto the future than either alone. Markets are at their best when they can synthesize large amounts of disparate information, as on an election night. Experts are most useful when a system exists to identify the most truly knowledgeable — a system that often resembles a market.