Can markets predict elections? Alea summarizes last night’s primary results: Ooops! From my perspective, I find the ideas of markets predicting future events fascinating, if for no other reason than my original motivation for studying physics was tied up deeply in questions about predicting the future.
I believe that, fundamentally, we cannot predict the future. Why? Not necessarily because of quantum theory (did I surprise you there?) and not because of arguments based on chaos theory (and I worked at the Santa Fe Institute ? ), but because of the locality of physics. In a world with local laws, local entities do not have access to information which will allow them to predict their future. Information in your past light cone is not enough to predict your future evolution. To slightly bastardize John Archibald Wheeler: space-time locality is what prevents anyone from knowing everything. For want of locality, we would be time travelers, able to predict our future with Laplacian certainty.
There are good reasons why markets can sometimes be efficient predictors. One central reason is that they aggregate information across multiple sources. But, just as in physics, information external to those who are betting in the market can become important and can ruin the predictive powers of the market. Last night, I think, information external to the market players and that influenced the election result was not available to the market. What was this information? My bet would be on people’s backreaction to misogyny like this (warning: clicking on that link may make your blood boil, or may have the opposite effect, depending on the color of your political underwear.), but in truth, I don’t know at this point what that information was.
But this is exactly what I find fascinating about last night’s results in the primary: unlike in other cases where the information was readily available far prior to the market being priced incorrectly (as in, say, a bubble market), it seems that last night was an example of the information simply not being available to the market players. The failure seems less from a bubble of speculation, and more from a fundamental property of markets as information processing entities. And it is for this reason that I don’t spend my days worshiping at the feet of the efficient market hypothesis, or thinking that markets for predicting terrorism have any chance at succeeding. While the former may have application as an approximation, I believe at a very fundamental level the efficient market hypothesis cannot possibly be true. And as for the later, since terrorism is (sadly) centered on secretly coming up with new evils to enact upon our collective security, I believe markets for predicting future terrorism are next to useless. Markets are local information processing entities with their own sense of locality (to be clear the speed of information flow in markets is not as clear cut as in physics, but it is there, nonetheless), and, just like the world we live in, this means that fundamentally we cannot rely on markets to predict the future, any more than we can use the laws of physics to predict our future. Now, if you don’t mind, I’ve got to go and check on the prices of equities I own.