Why markets come up with right answers Financial Post Jason Chow Financial Post 02 August 2003 National Post (Canada) FP1 / Front Washington balked this week in its controversial plan to offer traders a chance to buy futures contracts on, among other things, the odds of an overthrow of the King of Jordan. But while the Pentagon's futures market failed for political reasons, the rationale behind using market efficiency to predict events in public affairs has been proven to be successful. Investors can already bet on the outcome of the chase for Al Qaeda leader Osama bin Laden and bid on the winner of the 2004 U.S. presidential elections. Earlier this week, it was revealed the Pentagon was designing a market that would have allowed traders to place bets on terrorist attacks and political events in the Middle East. The Pentagon was hoping its Policy Analysis Market (PAM) -- the name of the ill-fated idea which was canned on Tuesday, only a day after the project was leaked to the public by two Democratic senators -- would help the U.S. government intelligence agency predict events in the troubled region. Though it was a public relations nightmare, fraught with objections of using public money to fund such an exchange and fears that terrorists might take large positions on the outcome of an attack and carry them out themselves, economists say, the idea in itself was a gem -- both in its predictive abilities and in its broad appeal. "It's bad publicity," said economist Robert Shiller at Yale University in New Haven, CT and author of Irrational Exuberance. "But this idea could have worked, and it likely would have revealed information, just the same way way as if you put up a US$15-million bounty for the heads of Uday and Qusai Hussein [sons of Iraqi leader Saddam Hussein]." Alternative markets have been sprouting for some time to receptive audiences with strong reputations for being accurate. The pioneering alternative futures exchange was the Iowa Electronic Markets, started in 1988, which allowed individuals to bet on the outcome of U.S. presidential elections. Research has shown that the IEM, even with its relatively small population of traders, has been a more effective forecaster than general opinion polls. There are other similar exchanges. Dublin-based TradeSports.com has been the most active leader in the trading of futures contracts on political and cultural events. There, you can buy and sell contracts based on when you think Saddam Hussein will be captured and on whether you think basketball star Kobe Bryant will be found guilty on sexual assault charges. TradeSports attracted attention earlier this year when its futures contract on the date of the invasion into Iraq was on target. The Athletic Stock Exchange allows individuals to ride the fortunes of sports stars while the Hollywood Stock Exchange allows online traders to bet on the box-office success of upcoming releases. For example, next week's release of S.W.A.T., starring Colin Farrell, is being pinned as a bust, trading down US$5.67. Why are markets so effective at predicting the future? Simply, markets can act as essentially virtual meeting places, where people get together to pay and profit for their opinions, economists argue, and the distilled collective thinking of several trumps the forecasting abilities of the individual. Take the jar of jelly beans experiment: Ask a hundred people how many beans they think are in the jar. It's highly unlikely any one of the responses would have the exact number, but if you take the mean of all their answers you'll probably be close to the mark. Markets are the same, economists say. Several participants are forced to answer an identical question -- i.e. Will current U.S. President George Bush win a re-election in 2004? -- and have to pay for that privilege. Stanford University professors Eric Zitzewitz and Justin Wolfer, who have been researching TradeSports and the Saddam futures, say markets reflect more wisdom than any single individual can possibly have, and therefore are more effective of assessing probabilities. "The market is one of the best aggregators of information," said John Delaney, chief executive of TradeSports.com. "In essence, I'm asking people for their opinions, but asking them to back it up with real money. They have to put money where their mouths are." There's also a psychological element, says Mr. Shiller at Yale, who also runs a private research firm that is currently looking into the creation of markets for house prices and other macroeconomic indicators. The market appeals to those who like to gamble, he says, while at the same time, forces people to think harder about their opinions. "There's a gambling instinct and it's human nature," he said. "When people are asked their opinions for a survey, they'll say whatever first comes to mind. But if they have money on the line, they'll likely think twice. It's more honest. They'll say what they really believe in." Of course, not all market predictions are on the money, even those made on alternative markets. Earlier this week TradeSports offered a futures contract on whether John Poindexter, head of the Pentagon's Defence Advanced Research Projects Agency and leader of the PAM initiative, would be able to keep his job after all the controversy surrounding the proposed market. Traders on the TradeSports were pricing in a 65% chance of him still being on the Pentagon payroll at the end of August. Mr. Poindexter was fired on Thursday. TRADING PEOPLE LIKE STOCKS: IOWA ELECTRONIC MARKETS Started in 1988, the market forecasts the fortunes of presidential candidates. Starting accounts are capped at US$500. ATHLETIC STOCK EXCHANGE Sports fans can buy shares in sports stars like New York Yankee outfielder Hideki Matsui (ticker: MATS) and ride their fortunes. The Quarterback Pool tracks the average performance of all NFL quarterbacks. Entry fee: $10. TRADESPORTS.COM News and political junkies can bet on current events. When will Saddam Hussein be captured? Will Kobe Bryant be found guilty? Is Gray Davis going to lose his title as Governor of California? Most contracts cost $10 apiece. HOLLYWOOD STOCK EXCHANGE The HSX trades "MovieStocks" whose value are determined by the boxoffice success of upcoming releases and "StarBonds" which are tied to the future successes of those already on the silver screen. jchow@nationalpost.com;Business List: National Post / Trading People Like Stocks: (Online); Black & White Photo: George W. Bush; Black & White Photo: Jennifer Lopez; Black & White Photo: Saddam Hussein; Black & White Photo: Hideki Matsui