Wisdom of the Crowds

If you’ve ever watched the show “Who Wants To Be A Millionaire?” you know that one of the most reliable lifelines is asking the audience.

So reliable that the odds of getting led to the right answer approaches 90%. The power of this collective intelligence, while maybe surprising, isn’t anything new and has actually been widely documented in both economic and psychological literature.

One small company to watch here you may have already heard mentioned on CNBC or Bloomberg. It’s called Intrade. Based out of Ireland and with registered members from 162 countries and a 82,000 membership, the website brings together a diverse crowd and the potential for a lot of predictive power.

James Surowiecki in The Wisdom of Crowds, points out a few requirements for a crowd to possess a “collective intelligence” which he argues can be much more reliable than any single “expert.” Intrade uses all of Surowiecki’s preconditions namely: (1) diversity of opinion; (2) member independence; (3) decentralization and (4) a good method of aggregating opinions.

While Intrade has all the bases for this predictive engine covered, how did they get so many willing members to participate you ask? Profits of course. Intrade works in a similar way to an exchange for options trading. To start, you deposit some funds into an account with Intrade and use this to purchase contracts and bet directly on events (each contract is valued at $10 USD). These events can be anything, from how long the recession will last and political events to American Idol winners.

Take the event on the front page of Adam Lambert winning American Idol. As of today, the contract is selling (bidding) at 65.5. Each point on a contract is actually .10 cents, so if you had decided to purchase a contract at 65.5, you would be putting down $6.55. If Lambert wins American Idol, the contract will close at 100 points, making you a profit of $3.45 ($10-$6.55). If he looses, the contract expires at 0 and you lose your margin of $6.55. Another element that plays in is that you can sell your contracts at any point before the event actually occurs, as long as you have a willing and able party on the other side of the contract.

Given this, contracts trading at low values can have the potential for an incredible ROI even before an event occurs. This human-powered predictive engine can be useful not just for betting on events, but also hedging, or understanding probabilities of complementary events for the less liquid contracts.

In the case of the next American Idol winner the crowd has him at 65.5% from the top 10. Nothing absolute, but combined with my Mom’s prediction, a faithful American Idol viewer who predicted each winner from the top 10 in the past 6 seasons, my money is on Adam. Definitely a way to make the show interesting.