A well-known experiment, run by Iowa

Electronic Markets, allows traders to place bets on the outcome

of political elections, including the current California governor’s

race. According to a paper

by Joyce Berg and others, the Iowa Political Market has

outperformed polls in predicting 9 out of 15 elections. Its

average error in predicting election results is about 1.5%, compared

to about 2% for an average poll. In some past elections, the Market

avoided major errors that marred all the major national surveys, whereas

it has never made a gross mistake itself. The apparently uncanny ability

of the Iowa Electronic Market to predict the future was one of the

reasons that the Defense Department recently floated the grisly idea

of a futures market in terrorism.

I’m struggling to understand the theoretical explanation for this

phenomenon. I realize that markets efficiently aggegrate the knowledge

of investors (who must try to make honest predictions, since their

money is on the line). But where do the investors in a political futures

market get their knowledge? They cannot simply ask themselves

how they intend to vote. As Berg et al. note, traders are "not

a representative sample of likely voters; they are overwhelmingly

male, well-educated, high income, and young" (p. 2). Some are

not even US residents. Thus their own choices in the real election,

assuming they vote at all, will be very different from those of the

American people. Yet they seem to be able to predict the actual result

more accurately than a random-digit telephone poll.

One clue is that a relatively small number of "marginal traders"

drive the market; they make many more trades than other people and

are less prone to sticking with an unlikely bet out of loyalty. I

would guess that these "marginal traders" are political

junkies: people who have no sentimental attachment to any of the candidates

but love to prognosticate about elections. We can assume that they

have seen all the polls—but that still doesn’t explain how they

outperform surveys on average. Could it be that they instinctively

recognize a consistent error in polling, and adjust accordingly? For

example, maybe polls tend to pick the real winner but predict a larger

margin of victory than actually occurs. (Races tend to "tighten"

right at the end.) Or maybe polls tend to make inflated predictions

for the Democrats’ share of the vote, because they count too many

low-income people as "likely voters." It’s also possible

that the marginal traders rely on one or two polls that are better

than the average. (Then we would find that the market outperformed

polls in general, but was no more accurate than the best of the polls.)

These are hypotheses backed with no evidence. But if one of them

turns out to be true, then we don’t need a market to improve on surveys.

We just need to make the same adjustment to poll results that the

marginal traders (a.k.a., the political junkies) are making. Likewise,

we would not benefit from a futures market in terrorism, but we should

strive to understand how the best informed and least sentimental observers

of terrorism make their predictions.