I had to chuckle when I read the following on Bloomberg yesterday:
Paddy Power Plc said it was left “red-faced” after paying out early to gamblers who incorrectly bet that Greek voters would back an austerity referendum. Ireland’s biggest bookmaker “paid out five figures” in winnings on July 1, days before Greece rejected further austerity, with a larger-than-forecast 61 percent of the vote for the “no” campaign. – Paddy Power Left ‘Red Faced’ After Early Payout on Greek Vote
The delicious irony of a prediction market making an early payment on an incorrect prediction of a political referendum was simply too wonderful to pass up without comment. So today’s column is on why predictions markets fail, and that contrary to common beliefs, the crowd often has surprisingly little wisdom.
The “wisdom of crowds” is a colloquial way of describing the market as a complex system. The work on wisdom of crowds shows that when certain conditions are met — diversity, aggregation, and incentives — markets tend to be efficient. Conversely, when one or more of those conditions are violated, markets can and do become inefficient, i.e., price is no longer an unbiased reflection of value. – Michael Mauboussin (emphasis added)
Wisdom, “having the quality of having experience, knowledge, and good judgment,” hardly describes the random, chaotic behavior of markets in general, but especially does not describe prediction or betting markets.
Before we get into the details, a preface: Markets are by definition a crowd.
Continues here: The ‘Wisdom of Crowds’ Is Not That Wise
The economists like to believe in the Efficient Market Hypothesis because of the “Wisdom of Crowds” but ultimately, journalists get to write about the extraordinary popular delusions associated with the “Madness of Crowds”.
There is no “wisdom” in markets. Markets are simply a summation of actions of people with varying levels of intelligence and varying motivations. It is impossible for a *market* to be smarter than its individual constituents. For the same reason, individuals have a tough time beating markets.
“Think of how stupid the average person is, and realize half of them are stupider than that.” -George Carlin
If markets were really wise and capable of correctly anticipating the future, there would be little fluctuation. Prices would increase by a small amount every day.
Where things go off the rails is when investing becomes a process of trying to figure out what the other guy is going to do. Not coincidentally, the other guy is also trying to guess what you will do.
What smart person ever thought crowds are wise?