James Surowiecki: The Wisdom of Crowds

In the last post we talked about Intrade, which (along with other online betting and prediction sites such as Newsfutures) has a novel manner of predicting the future: letting the people decide.

A specific, factual prediction is made. If you believe it will happen, you buy shares, if you believe it won't happen, you sell shares. The prices at which you, individually choose to buy and sell reflect the strength of your conviction. The price of the stock fluctuates with each trade: essentially, the price of the stock at any given moment is the price that the latest person who bought it paid for it. That price is always between $0.00 and $10.00, and the "collective perception" of the probability of the statement's truth is 10 times the price of the stock.

The major question underlying this system is: why should we believe that a bunch of people laying bets and buying and selling stock knows anything about what's going to happen or not happen? They're not experts, what do they know?

Ah, but as it turns out, apparently they do know. Research has shown again and again that the dominant opinion of a crowd (if it's a yes or no question) or the average opinion (if it's a numerical question) tends to be closer to the truth than the opinions of individual experts, no matter how expert they may be.

For example, a 1984 study showed that the price of orange-juice futures was a more reliable weather predictor, in certain citrus-growing states, than the U.S. Weather Service forecast!

Much earlier, 19th century anthropologist Francis Galton was both surprised and impressed to discover that at a county fair guess-the-weight-of-the-ox competition, the average of the guesses of the 800 farmers present was astonishingly close to the actual weight of the ox - closer than all but a very few of the individual guesses, and closer than all of the guesses made by cattle experts present at the event. (It is said that Galton's observation greatly reinforced his faith in the system of democracy.)

But everyone knows that crowds can be swayed into wild, irrational behavior - stock market panics, lynchings, mass hysteria. So why should the wisdom of crowds be trusted?

One James Surowiecki, staff writer at The New Yorker, has developed a simple and striking theory to answer that question. According to Surowiecki, for a crowd to be a "wise crowd", it needs to have four qualities:

1) Diversity of opinion: Each person should have private information even if it's just an eccentric interpretation of the known facts.

2) Independence: People's opinions aren't determined by the opinions of those around them.

3) Decentralization: People are able to specialize and draw on local knowledge.

4) Aggregation: Some mechanism exists for turning private judgments into a collective decision.

[This table summarizing Surowiecki's theory was drawn directly from the Wikipedia entry on "The Wisdom of Crowds".]

In examples of collective error or misbehavior, at least one of the elements above is missing from the crowd; most generally "independence", as the anger behind a lynching or the panic leading to a financial crash are highly contagious.

But, based on many studies, Surowiecki demonstrates that the predictive ability of "wise crowds" is remarkable.

Estimating the probabilities of possible outcomes of factual matters is fundamental in developing strategy. So if a "wise crowd" can make some of those predictions for us, let us by all means pay attention.

Dominique Strauss-Kahn: situation reversal!

"Right now the odds of a conviction for a felony are hovering around 8.5% for DSK, according to Intrade, an online betting forum", I just read on a blog.

Intrade? Strauss-Kahn? An online betting forum for outcomes of current events?

Yes - it really exists! Chances for Strauss-Kahn to be convicted of at least one charge have just gone up a little, actually, from 8.5% to 9.1%.

Well, contrary to all expectation, Strauss-Kahn's accuser's credibility has just collapsed completely, and the case against him pretty much along with it. Gone are the ankle bracelet, the house arrest and the gigantic bail. Strauss-Kahn is free on his own recognizance, without a passport but able to travel within the U.S. His next court date is July 18.

Two posts ago, I was talking about developing strategy in a risky situation and using the Strauss-Kahn affair as an example. To develop strategy, it's necessary to be able to predict outcomes. That is exactly what Intrade is doing.

So what is their method? It's simple and brilliant, based on collective perception. Anyone who wants can place a bet of "Yes" or "No" to the statement "Dominique Strauss-Kahn to be found guilty of at least one charge", and each bet is associated to two quantities: the number of shares you buy (if you bet "Yes") or sell (if you bet "No"), and the price of those shares, which changes at each new bet. Every share price is between $0.00 and $10.00, and the probability of the "Yes" outcome at any given moment is equal to 10 times the price of the share. Shares can only be bought and sold by betters, not by Intrade. It is possible to offer for sale shares you don't own: you name your own sale price, but you have to buy them back later. If you wait till the event happens and your prediction is right, you buy them back at $0.00 so all the profit is yours, but if you were wrong, you have to buy them back at $10.00, which is more than what you sold them for. (In fact, you can buy or sell shares at the going price or name your own price at any time. For instance, you might want to sell at a lower price than the going price if you just want to get out of the whole story, or if you think that the situation is going to undergo a sudden reversal. But that will only work if you can find a buyer or seller who agrees with your proposed rate.)

How do predictions get started on Intrade?

A new statement is made, for example, "Dominique Strauss-Kahn to be elected President of France in 2012".

Shares for sale and purchase offers are visible. The site shows buyers offering to purchase a total of 10,179 shares at tiny prices ranging between $0.01 and $0.50, and 30 shares being offered for sale at about $9.99. This is indicative of a very low rate of belief that Strauss-Kahn will be the next French president.

(Personally, I might be willing to bet that he will, but making a $3.00 profit is not worth my trouble.)

None of these offers have found any takers yet, so there is no "going price" and no outcome prediction at present.

But once trades start - once someone offers a sale and another person accepts to purchase at that price - the share price is fixed, and the outcome probability is taken to be 10 times the share price.

Back to the question of whether Dominique Strauss-Kahn will be convicted on any of the seven original counts: I've just joined Intrade, and sold 10 shares at $0.84 - I believe he's going to walk free.

My action brought the prediction that he'll be found guilty down from 9.1 % to 8.3 %.

If he goes free, I make $8.40 ! :D

If he doesn't, I lose $91.60. :(

What that means is that most people agree with my prediction. Intrade is using collective perception to make predictions and that is a very neat idea.

In my next post, I'll talk about the fact that collective perception from a diverse group of people works better for predicting outcomes than either polling or asking experts.

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Let me end this post by offering a white rose of respect and sorrow for Intrade's founder, Irishman John Delaney of County Kildare. A band at the top of Intrade's main page informs us that he died two weeks ago, 50 metres below the summit of Mount Everest, a summit he had always longed to climb. Delaney leaves behind his wife, two sons aged three and two and a tiny daughter, born just two days before his death. My heart goes out to them.