Please fasten your seatbelt and try to beat the market

Scott Sumner and other Market Monetarists (including myself) favour the use of NGDP futures to guide monetary policy. Other than being forward-looking a policy based on market information ensures that the forecast of the future development is not biased – in the market place biases will cost you on the bottom-line. Similarly, I have earlier suggested that central banks should use prediction markets to do forecasting rather rely on in-house forecasts that potentially could be biased due to political pressures.

A common critique of using “market forecasts” in the conduct of monetary policy is that the market often is wrong and that “herd behaviour” dominates price action – just think of Keynes’ famous beauty contest. This is the view of proponents of what has been termed behavioural finance. I have worked in the financial sector for more than a decade and I have surely come across many “special” characters and I therefore have some understanding for the thinking of behaviour theorists. However, one thing is individual characters and their more or less sane predictions and market bets another thing is the collective wisdom of the market.

My experience is that the market is much more sane and better at predicting than the individual market participants. As Scott Sumner I have a strong believe in the power of markets and I generally think that the financial markets can be described as being (more or less) efficient. The individual is no superman, but the collective knowledge of billions of market participants surely has powers that are bigger than superman’s powers. In fact the market might even be more powerful than Chuck Norris!

Economists continue to debate the empirical evidence of market efficiency, but the so-called Efficient-Market Hypothesis (EMH) can be hard to test empirically. However, on Thursday I got the chance to test the EMH on a small sample of market participants.

I was doing a presentation for 8 Swedish market participants who were on a visit to Copenhagen. I knew that they had to fly back to Stockholm on a fight at 18:10. So I organized a small competition.

I asked the 8 clever Swedes to write down their individual “bets” on when they would hear the famous words “Please fasten your seatbelts” and the person who was closest to the actual time would win a bottle of champagne (markets only work if you provide the proper incentives).

“Fasten your seatbelts” was said at 18:09. The “consensus” forecast from the 8 Swedes was 18:14 – a miss of 5 minutes (the “average” forecast was 8 minutes wrong). Not too bad I think given the number of uncertainties in such a prediction – just imagine what Scandinavian winter can do to the take-off time.

What, however, is more impressive is that only one of the 8 Swedes were better than the consensus forecast. Carl Johan missed by only 1 minute with his forecast of 18:08. Hence, 7 out 8 had a worse forecast than the consensus forecast. Said in another way only one managed to beat the market.

This is of course a bit of fun and games, but to me it also is a pretty good illustration of the fact that the collective wisdom in market is quite efficient.

I showed the results to one of my colleagues who have been a trader in the financial markets for two decades – so you can say he has been making a living beating the market. The first thing he noted was that two of the forecasts was quite off the mark – 14 minutes to early (Erik) and 14 minutes to late (Michael). My colleague said “they would have been dead in the market”. And then he explained that Erik and Michael probably went for the long shot after having rationalized that they probably would not have any chance going for the consensus forecast – after all we were playing “the-winner-takes-it-all” game. Erik and Michael in other words used what Philip Tetlock (inspired by Isaiah Berlin) has called a Hedgehog strategy – contrary to a Fox strategy. “Foxes” tend to place their bets close to the consensus, while “hedgehogs” tend to be contrarians.

My colleague explained that this strategy might have worked with the “market design” I had set up, but in the real world there is a cost of participating in the game. It is not free to go for the long shot. This is of course completely correct and in the real market place you so to speak have to pay an entrance fee. This, however, just means that the incentive to move closer to the consensus is increased, which reinforces the case for the Efficient-Market Hypothesis. But even without these incentives my little experiment shows that it can be extremely hard to beat the market – and even if we played the game over and over again I would doubt that somebody would emerge as a consistent “consensus beater”.

From a monetary policy perspective the experiment also reinforces the case for the use of market based forecasting in the conduct and guidance of monetary policy through NGDP futures or more simple prediction markets. After all how many central bankers are as clever as Carl Johan?

PS Carl Johan works for a hedge fund!

PPS if you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

UPDATE: See this fantastic illustration of the Wisdom of the Crowd.

Update 2: Scott Sumner has yet another good post on EMH.

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