I’d been thinking a lot about bets recently.
One evening a while back I was working late in my office on the Caltech campus, and I decided to take a break by dropping into a lecture by a Caltech economist (why not? I didn’t know anything about economics. No better time to learn) who had described experiments they had been performing demonstrating the efficiency of markets at collecting, analyzing, and making decisions based on diffusive knowledge. The specific example that still sticks in my head more than a decade after I heard this single lecture was the real-life case of a computer manufacturer trying to predict next month’s price of computers and printers. Several people in the company were supposed to be experts at these predictions, but they rarely got the right answer. The experiment that the Caltech economist ran involved letting everyone at the company who had any sort of knowledge about any part of the process participate in a predictive market, where they could buy “shares” in a certain price point, or essentially bet on what the price next month was going to be. If they were wrong, all of the shares that they bought were worthless, but if they were right they could win big. This was simple betting, but with a twist. The market price of the “shares” somehow reflected all of individual thoughts and hopes and speculations of what the price would be. No one thought that a computer was going to cost twenty dollars, so you could buy shares of “twenty dollars” for next to nothing. Of course, they were pretty much guaranteed to be worth absolutely nothing, which is less than next to nothing, so you would lose money. As you got closer to the price that most people thought the computers were going to be next month the cost of the shares rose.
All of this experimentation could be considered an interesting exercise except for one astounding point: the economists found that the market was better at forecasting the future price than the “experts” were. Somehow all of the individuals were able to exchange and synthesize information simply by buying and selling shares of prices and all of this information exchange led to better predictions than anyone else was able to make.
As I sat and listened to this that evening at Caltech I was shocked and astounded and excited. Scientists had always thought they had a monopoly on the best way to predict things (“the scientific method”) and yet here was a totally non-scientific method that seemed to lead to truth in a pretty clear way. It was a strange truth: not one proved with postulates and experiments, but one simply deemed the most likely.
Before getting too carried away with these ideas, though, I also learned at that lecture that markets aren’t perfect predictors and that the economists could run similar experiments where, with a few simple tweaks, they could make market bubbles and other odd effects. This fact would come as no surprise to anyone who has read a newspaper in the last few months.
I walked back to my office that night with my head trying to reconcile science and markets. OK, so perhaps this market approach couldn’t lead to truth in quite the way that the scientific method could, but maybe there was still a place for it. What about scientific markets for things that can’t quite be proven beyond sufficient doubt but that most scientists would be willing to bet a lot on. The first thing that came to mind was climate change. To most earth scientists, the only arguments about climate change are precisely how strong an affect it will be in different places. But somehow, because of the complexities of the questions, the public frequently sees the disagreement over the uncertainties rather than the fundamental agreements. Clearly, this was a place where a market could work. What about betting on the magnitude of climate change? Buying shares of the average temperature rise by 2050?
While this was all fun speculation, it also seemed obvious that given that the people were confused by the science, they were just as likely to be confused by scientists buying shares in a future temperature market. Clearly this was interesting, but going nowhere. But what about just using the ideas amongst scientists? If I could get all of the astronomers around to buy into a market on whether or not earthlike planets would ever been found around other stars, for example, I would have an effective way of collecting all of the disparate information that everyone had and coming up with the best prediction based on all of the data.
But then I realized that the idea could be taken one step further. Scientists could engage in what amounts to insider trading in markets! If I really believed, for example, that the climate was warming, and that, for the most part, the rest of the world was not dealing rationally with that fact, I should buy land somewhere in central Canada where it is right now too cold for most people and then I should reap the incredible returns when the land prices skyrocket because people can no longer live in Los Angeles anymore (as crazy as this sounds, I know one scientists who independently came to the same conclusion and bought himself some [currently] chilly property in Minnesota). A market does exist for climate change speculation, only it is a bit more indirect than simply betting on temperatures.
As a mere professor, I don’t have the financial means to follow up on my late night thoughts, but the ideas still continue to percolate in my head. I remain convinced there must be a way to figure out something about which you were certain but which was not generally understood and then use that knowledge to hit it big.
It is a testament to my general lack of financial thoughtfulness that after all of this interesting speculation and pondering about bets and markets and scientific insider trading that the best I ever came up with for my own personal attempt to hit it big with a piece of scientific speculation was a bet made in 2000 that someone would find a tenth planet before January 1st, 2005, with the winner of the bet to receive five bottles of champagne. Perhaps it is also a testament to my happiness at drinking champagne.