Harnessing the Wisdom of Crowds

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Harnessing the Wisdom of Crowds

In the best-selling book, The Wisdom of Crowds,1 author James Surowiecki describes the experience of the Victorian polymath, Francis Galton, at a county fair. The people in attendance were asked to guess the weight of an ox. No one could come close to the right number.

But Galton discovered an ingenious method: He averaged the guesses of all of the ordinary spectators. The number was not only correct; it was more accurate than those given by cattle experts.

Modern statisticians have observed that the people who bet at racetracks invariably prove themselves much better at predicting the outcome of any given race than the experts. The odds on any horse are set by the amount that everyone bets, and a horse with three-to-one odds wins one-fourth of the time, while a horse with six-to-one odds wins one-seventh of the time.

This phenomenon extends beyond guessing the weight of oxen and picking the fastest horses; it even applies to the most important contest in the world. According to Business 2.0,2 betting on U.S. presidential elections was common from the late 1800s until the 1940s. People could make bets in the form of “futures contracts” they could buy on various candidates on Wall Street, and The New York Times printed the odds.

Those odds turned out to be uncannily accurate. Economics experts Paul Rhode and Koleman Strumpf calculated the results over a half-century of elections and found that candidates with betting odds of 60 percent or better on the day of the election won nine out of 10 elections.

In other words, the candidate that most of the betting public expected to win usually did win. The other candidates were picked to win by fewer bettors, and they also received fewer votes. The market was much more successful at picking the winners of elections than today’s pundits on cable news networks with their wealth of data from exit polls and computer-generated projections of election outcomes.

Yet, even though the predictive power of the market was clear to anyone who followed elections in the first half of the last century, not much was done with that information until 1988. In that year, Jesse Jackson unexpectedly won the Democratic presidential primary in Michigan, and economists at the University of Iowa took note.

They theorized that the knowledge of who would win the primary would not have been a surprise if someone had tapped into the collective knowledge of the crowd. They developed the Iowa Electronic Market to allow students to invest real money, buying contracts on political candidates based on their predictions of who would win...

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