In the good old bad old days of corrupt Chicago politics, the voters were urged by city bosses to “vote early and often.” Now that’s exactly what you can do — and you might even make some money at the same time. If nothing else, you’ll be participating in an important experiment taking place at the intersection of free elections and free markets.
It’s simple. Just open an account on-line with the Iowa Electronic Markets at http://www.biz.uiowa.edu/iem, and in a matter of minutes you’ll be able to trade exchange-listed futures contracts on political elections. This is no simulation — these are real futures contracts, and you’ll be putting real money at risk. Right now you can buy and sell four different political futures contracts, each representing a different outcome of the congressional elections this November.
If you buy the Republican House/Republic Senate contract (RHRS), you’re betting that the GOP will win majorities in both houses of congress on November 5. The Republican House/Not Senate contract (RHNS) is a bet that they’ll do no better than hang onto their current control of the House of Representatives, while the Not House/Republican Senate contract (NHRS) is a bet that they’ll give up the House but win control of the Senate. The Not House/Not Senate contract (NHNS) is a bet the GOP will lose (or tie) both ways.
These are “winner take all” contracts — the four possible outcomes are mutually exclusive: one and only one will actually happen. After the election the winning contract settles for $1.00 — in other words, the IEM will pay holders of that contract $1.00 for each one they hold. All the others will be worthless.
With a maximum possible value of $1.00 and a minimum of zero after the election, all the contracts will trade somewhere between those two values until the election. For example, yesterday the Republican House/Republican Senate contract was trading at $0.38. If the GOP wins control of both houses, that contract will pay off $1.00 after the election, for a profit of $0.62 — that’s a gain of 163% in about a month.
A tantalizing speculative opportunity — but more significant is the role the IEM can play as a forecasting tool. Trading at $0.38, the market has determined that — at this moment — the probability of the GOP winning control of both houses is 38%. If you believe — as I do — that nothing is more important than federal government policy in setting the direction of the economy, then these contracts can help set the backdrop of your investment strategy.
As readers of this column know, I’m way not thrilled with the way the Bush administration is handling the economy — but I’m downright terrified of the idea that the Democrats could get any more control than they’ve already got. So I’ve become somewhat more bullish over the last month as the Not House/Not Senate contract fell from $0.40 (a 40% probability of the Democrats taking both houses) down to only $0.19 yesterday (a 19% chance).
Of course the NHNS contract took a big dive this week thanks to the withdrawal of Robert Torricelli from the race for New Jersey senator. This is seen by the IEM’s traders, apparently, as enough to seriously endanger the Democrats’ chances of hanging on to their one-seat lead in the Senate.
Now, based on the RHRS and RHNS contracts together, there’s a 76% chance that the Republicans will keep their majority in the House of Representatives. Based on the RHRS and NHRS contracts together, there’s a 44% chance they’ll take control of the Senate. And based on the RHRS contract alone, there’s a 38% chance they’ll take control of both houses.
No other poll can provide this kind of information. The IEM condenses hundreds of separate congressional and senatorial elections around the country into a single set of forecasts. And it expresses those forecasts in terms of probabilities. Can you imagine a typical pollster knocking on doors and asking, “Excuse me, madam, but what do you think the odds are for the four ways that congressional control could turn out?”
And no other poll can be this accurate. When the IEM was founded in 1988 at the business school of the University of Iowa, it was an experiment to see if the processes that financial markets use to consolidate information about companies into stock prices could be applied to elections — and it worked.
According to Robert Forsythe, senior associate dean of the University of Iowa’s Tippie College of Business and one of the IEM’s founders, the IEM generally forecasts elections within a 1% margin of error, while traditional polls usually have 3-1/2% to 4% margins of error. Forsythe explains, “As economists, what we like about this is it makes people put their money where their mouth is.”
Formally, the IEM is a living, breathing laboratory for what financial economists call the “rational expectations hypothesis.” University of Chicago economist Robert Lucas won the 1995 Nobel Prize for this theory that explains how investors process information in markets — it’s the mechanism that makes efficient markets so efficient.
“Given the right incentives,” Forsythe says, “individuals will collect the relevant information and forecast an outcome. Markets serve to both aggregate and disseminate that information in the form of prices. Every time you trade you learn something from the people you are trading against.”
The IEM is regulated as a futures exchange by the Commodity Futures Trading Commission. The CFTC has agreed to exempt the IEM from most of the rules that apply to typical futures exchanges and people who trade on them. So it’s easy for anyone to open an account online and get trading right away, without filling out reams of forms and without posting very much money. In fact, the CFTC limits the amount of money that can be deposited in IEM accounts to a maximum of $500.
So give the IEM a try. I’ve tried it — and I’ve made money at it. And in the process I learned a lot about myself as a trader. Trading something as unusual as election results really made me stop and ponder a fundamental question that most investors conveniently ignore most of the time: do I really know as much as I feel I know about this investment?
Iowa’s academics use the IEM to understand how investors deal with questions like this when they make trading decisions. Detailed surveys of the over 17,000 individuals who trade on the IEM reveal which decision methods make the difference between success and failure. For example, Forsythe told me, “We’ll survey our traders with the pollster’s question — who are you going to vote for in the election — and then see if they trade that way on the IEM. In other words, do they trade with their heads or their hearts?”
For most IEM traders, it’s their hearts. But they’re not the winners. Forsythe says, “People who support the Democratic candidate are more likely to buy the Democratic contract. But there are a handful of traders, typically not more than 5% or 10%, who really make this market work. If you look at who they plan to vote for, you’ll find they are completely unbiased. There is a relatively small handful of traders who are taking advantage of the majority of the biased traders.”
Sound familiar? How many investors bought technology stocks in 1999 and 2000, and rode them all the way down just because they thought the companies made cool products? Peter Lynch says “invest in what you know.” But who’s to say that what you know is a good thing to invest in just because you know it? The lesson of the IEM’s winning traders is just the opposite: “know what you invest in.”
— This commentary is Luskin’s “Ahead of the Curve” column for SmartMoney.com, October 4, 2002
