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.