How the election restored my faith in Capitalism

In the run up to last week’s elections (has it ONLY been a week?), I became intrigued with the electronic futures markets on the election. And how could I resist? This was a fusion of three of my favorite intellectual activities: Finance, Politics, and Technology.

For those of you who are unfamiliar with electronic markets, let me offer a brief overview of how one of them, Tradesports.com, works. Tradesports is a place where you can bet on the outcome of just about any imaginable topic. In addition to your standard sportsbook topics (over/under on Indy vs Dallas anyone?), tradesports also allows you to wager on such diverse topics as “Palestinian State by Year End”, “Category 3 or Higher Hurricane to hit named U.S. State”, and “2006 Year End Dow Jones Industrial Average”, just to name a few. Now I say “wager”, but I’m sure the folks at tradesports will take exception with that. Tradesports is more precisely a “futures market” where you can buy and sell “contracts” based upon your confidence that a certain event will or will not come to pass.

Contracts on Tradesports sell on a continuum of 0 to 100, which represents both the cost of the contract (1 point = $.10) and the consensus estimate of the percentage likelihood that a particular event would come to pass. Let’s use “Palestinian State by Year End” as an example. This contract is currently trading at 0.8 ($.08), which represents that the consensus estimate is that there is a .8% likelihood that this event will come to pass. If I were reasonably sure that there would be a Palestinian State established within the next 6 weeks (!!!?), then I’d want to buy a whole bunch of shares at this price. I would pay $.08 for every share I bought and if I were right, I would pocket a cool $9.92 on January 1st 2007, less a small commission – a 12,400% profit!

So why am I so fascinated by electronic futures markets? It pretty much boils down to this: These markets are said to predict world events with uncanny accuracy. They are often touted as a validation of the basic principles of market theory and the wisdom of crowds. The electronic futures markets successfully predicted the 2004 presidential election, the capture of Saddam Hussein, and the election of the new Pope, to name a few.

I became intensely interested in the electronic futures markets for the “US GOP Control” contracts during the run-up to the election, primarily because of the cognitive dissonance that they introduced into my expected outcome of the election. To be perfectly honest, I was operating under the assumption that we were seeing a replay of the 2004 elections, where the polls were WAY off and had again significantly over-estimated the projected Democratic gains. I was perfectly comfortable discarding the poll numbers because they had proven to be wrong many times before. But what to make of the futures markets?

First, lets take a look at the house: http://iemweb.biz.uiowa.edu/graphs/graph_HOUSE06.cfm According to the Iowa Electronics Markets on the Monday before the election, they were predicting a 20% chance that the Republicans would maintain control of the house. Again, this directly contradicted my intuitive sense of the direction of the race. What about the Senate? http://iemweb.biz.uiowa.edu/graphs/graph_SENATE06.cfm According to the IEM, there was approximately a 66% chance that the GOP would maintain control of the Senate. Both of these numbers were consistent with the conventional wisdom that the GOP would loose control of the house, but maintain control of the Senate.

So the obvious question became “Am I confident enough in my beliefs that I will put my own Money on the line?”. If I was right, I’d get 4:1 payback on anything I risked on the house, and 1:2 payback on the Senate. I’m generally very conservative with my money, and last week was no different. I don’t gamble on sports, I take a conservative approach to the Stock Market (SPY anyone?), and I am most certainly not going to throw my money away choosing sides between the two “sides” in our national politics. Had I played my hunch, I’d have lost my shirt.

The end result, of course, is that the electronic markets were correct for the House, and wrong on the Senate. So much for the much-vaunted predictive power of the electronic markets, right?

So how did this ‘failure’ in the markets restore my faith in capitalism? Simply put, while the consensus “wisdom of crowds” did not predict both contracts, the markets did function as designed. Those who had done the research, had better information, and were willing to back that up with cold, hard cash were appropriately rewarded. Those that let emotion and hunches play a role in their financial decisions were likewise punished by the market. At the end of the day, everyone involved settled their accounts, reflected on lessons learned, and then focused their energies on new opportunities.

Just like all good Capitalists do.