by Cass R. Sunstein
Post date 06.17.04 | Issue date 06.28.04

Review of The Wisdom of Crowds in The New Republic

File Attachment: Mobbed Up – Sunstein.doc (45 KB)

March Madness goes to market

Commodities traders to buy, sell on NCAA tourney

By John Powers, Globe Staff  |  March 16, 2005

When the opening bell sounds at the stock and commodities exchanges
around the country tomorrow morning, the traders will be buying and
selling the usual products — crude oil, gold, Treasuries, the S&P
500 index. Off the floor, after the close, they'll also be shorting
Duke, going long on Kansas, buying back Pitt, and dumping Alabama. When
March Madness begins, Longhorns are just another kind of cattle future.

While millions of Americans will be tossing a few dollars into
pick-the-winner office pools on the NCAA men's basketball tournament,
the traders will be playing a far more sophisticated game with much
more intensity for geometrically higher stakes.

In the commodities world, a contract is an obligation to buy or sell
a specific product at a set price on a set date. The contract value
goes up and down as the perceived value of the product changes. A
Mideast war or a peace settlement will affect the price of oil, a
drought or a bumper crop will affect the price of wheat, inflation or
deflation the price of gold. If the price goes up, a trader can sell
the contract and pocket a profit. If the price drops, he takes a loss.

The same theory applies to basketball teams during the tournament,
when perceived value rises and falls with results. A underdog that
knocks off a heavy favorite will go up in price. A favorite that goes
into double overtime to beat a lightly-regarded team will go down.

The average basketball fan makes bets. The trader deals in futures
contracts, which he buys and sells to his peers throughout the
tournament, even during a game.

Let's say a participant wants to buy 10 contracts on Boston College
winning the tournament title. Traders think the Eagles have a minimal
chance, so the price for each contract is low. For each round of the
tourney that BC advances, the price goes up. Traders can sell anytime
for a profit, but if the participant wants to ''buy more” BC, it will
also cost more.

''I attended a massive basketball school,” said an options trader
who deals in the S&P 500 Index, who like the rest of his colleagues
does not want his name used for fear of piquing the interest of the
Internal Revenue Service, the state attorney general, and the
Securities and Exchange Commission. ''But you get even more rabid
interest in the tournament here.”

For the next fortnight after the closing bell rings, the members'
lounges and bars will be jammed with traders — nearly all of them
male, most of them under 35 — watching games and monitoring their
positions.

In the trading world, everything is (or can be made) a market and all of them have the same characteristics.

''Any market is the sum total of intelligence, paranoia, greed,
fear, and idiocy,” said a former college basketball player who has
dealt in equities and commodities.

All of those elements are at a fever pitch during the NCAAs, which
provides several irresistible lures to traders, most of whom are
incurable sports junkies who will turn a PlayStation football game run
by a computer into a futures market.

March Madness is a single-elimination tournament with 64 teams and a
relatively quick expiration date (the final buzzer on April 4), which
makes for the volatility that traders crave. ''It's always dynamic,”
said an options trader who deals in the NASDAQ 100 Index. ''It's not
very static.”

And you can earn thousands of dollars even if none of your teams
makes it to the Final Four, simply by cashing in positions along the
way, as traders do with cotton and cocoa contracts every day.

In a standard NCAA pool, participants must fill out the entire
bracket and are married to the teams they choose. But traders can buy
and sell one or more teams multiple times throughout the tournament or
buy and sell the same team at the same time. They can even buy and sell
the seeds (all the No. 1s, all the No. 3s), conferences (Big East, ACC)
or the four bracket quadrants.

''What's beautiful about trading is that you don't have to hold onto
a team,” said Edward Kaplan, a Yale professor of management sciences
who co-authored a mathematical study of March Madness pools. ''You can
sell. You can triple your money.”

The way the March Madness market works, teams are priced from 0 to
100, depending on their likelihood of winning the tournament. Illinois,
for example, was a 22.2 this week, Wake Forest a 7.3, Connecticut a
4.7, BC a 1.1. The traders determine the prices by what they're willing
to pay, with a ''market maker” often serving as middleman. The longer
the tournament goes, the higher the prices on the survivors.

If a trader buys 10 contracts on Duke at 8.5, he is paying $85. If
Duke wins the tournament, the buyer collects $1,000 for a profit of
$915. If Duke loses, he loses the $85 he paid for the contracts. If
Duke makes the Sweet 16 and its price goes up to $17, the buyer can
sell his position and pocket $85.

''Guys are constantly finagling and taking profits,” said a trader
who was a market-maker for his colleagues during his days on the
Philadelphia exchange.

Trading is all about ''edge,” about exploiting the differences in
theoretical valuation between teams. Do you think UConn is underbid?
Buy it. Do you think Stanford is overbid? Sell. ''The predictable chaos
is what's captivating about the tournament,” said the S&P 500
options trader. ''There are so many variables, so many strategies, so
many opportunities to grind out some edge.”

Playing bracket pools is like playing the lottery. ''There are more
than nine quintillion possible outcomes,” said Kaplan, who has done the
math. ''If you count the play-in game, there are 18 quintillion. There
are about 6 billion people on the planet. If everyone put in 1.5
billion entries, only one person would get all of the picks right in
one draw.”

Depending upon how many contracts traders buy, they can make or lose
several hundred thousand dollars. The big losses come from selling
teams ''short” — traders selling contracts they don't own on a team in
the hope that the team loses early. If it does, the traders make a
profit. If the team keeps winning, they have to buy the contract back
at a price that can be brutally expensive, or trust in luck.

''One young kid at Paine Webber shorted the hell out of Duke the
year that they upset Nevada-Las Vegas [1991] and ended up losing
$200,000,” remembered a fixed-income salesman. ''Duke ended up beating
Kansas for the title, the kid didn't come into work the next day and
was never seen again.”

In a profession that depends on the honor system, where thousands of
dollars exchange hands at the flick of a wrist, failing to pay on an
NCAA contract is a major crime. ''This whole business is based on your
word being your bond,” said the S&P 500 Index trader. ''A few years
ago, a guy said he had sold a bunch of Duke when he had bought it.
Someone called his boss and he lost his job. Even if his boss hadn't
fired him, he would have been a pariah in the pit.”

So the market makers who run the NCAA futures are careful to make
sure that the players can honor their positions. ''There definitely are
risks and, if you're not careful, you can get burned,” said the former
Philadelphia trader. ''So, when I was doing it, we would only take bets
from guys we knew.”

The whole idea behind trading is to keep chasing the edge, which
changes game by game. Take BC, which probably was overbid when the
Eagles were 20-0. Now that they've lost four of eight, they've likely
been underbid. But if they make it to the Sweet 16 and Texas upsets
Illinois to soften the bracket, BC quickly could be overbid again.

''The guys who do the best are those who gamble the way they trade,”
said the S&P 500 index trader. ''As opposed to being traders who
are gambling.”

Most traders will be holding positions on multiple teams, which can
mitigate a big loss on one. ''I got my face ripped off on Carolina
contracts last year,” said the S&P trader, a Tarheel alumnus who
admits to betting with his heart. ''But because of how I did with other
teams, I only lost $500 instead of $3,000.”

Gambling is what they do in Vegas. What they do down around Wall
Street is about edge and hedge, even during March. ''Everyone on the
Street,” said the fixed-income salesman. ''knows about the kid at Paine
Webber who shorted Duke.” 

© Copyright
2005 The New York Times Company

Here are my notes on The Wisdom of Crowds by James Surowiecki

Overview

Under the right circumstances, groups are smarter than the
smartest people in them, even if the group doesn’t contain expert members.

Experts are as likely to disagree as agree. Experts’
individual consistency is also 0.5. Experts overestimate the likelihood that
they are correct – little correlation between self-assessment and performance.
Therefore, however well informed and sophisticated and expert is, his advice
should be pooled with that of others and the larger the group the better. So we
should stop “chasing the expert” and ask the crowd. We continue to chase the
expert because we assume average means least common denominator (Larrick and
Soll) and we are fooled by randomness (Taleb). 

Criteria for good
collective decision making

The group must be big enough and diverse enough, the members
must be forming opinions independently, and the group must be decentralized.

Diversity

To solve cognition problems you must 1) uncover alternatives
and 2) decide among them. Diversity is needed for both 1 and 2. Diversity adds
perspectives and weakens destructive characteristics of group decision making. A
successful system recognizes losers and kills them quickly. Homogenous groups
spend too much time exploiting and not enough time exploring (James March). Homogenous
groups are susceptible to groupthink, willing to rationalize away
counterarguments and often convinced that dissent is bad. Diversity is more
important than individual intelligence but members must be somewhat informed. There
has to be some information – can’t have a completely ignorant group. 

Independence

Independence
means members can’t be dependent upon one another for information and can’t be
subject to influence from one another. Independence
keeps mistakes from being correlated. Members can be biased/irrational without
making the group dumber. The more influence members exert on each other, the
more personal contact, the dumber the group will be. This is difficult to
enforce because

• members
  want to learn from one another
• members
  are affected by environment/neighborhood/hierarchical position
• groups
  become more influential as they get bigger
• “It’s
  better for reputation to fail conventionally than to succeed
  unconventionally” Keynes
• Information
  cascades can occur when members make decisions in sequence rather than
  simultaneously. That is, the first deciders influence the subsequent even
  if they are wrong. If the subsequent start following the crowd then the
  cascade stops informing. (From The
  Tipping Point, cascades move via social ties – mavens, connectors,
  salesmen) 

There also must be intelligent imitation not slavish.

• Intelligent:
  people stop imitating and learn for themselves when the benefits of doing
  so become high enough
• Slavish:
  people just keep imitating no matter what

To get intelligent imitation

• There
  needs to be initially a wide array of options and information
• Some
  members must value their own judgment ahead of group’s – overconfident
  people who go with their gut or systematically test and adopt 

Corporations should incentivize employees to uncover and act
on private information. (Blasi and Kruse, High Performance Work Systems).

Decentralization

Decentralization- specialization plus coordination. The best
collective decisions are the product of disagreement and contest, not consensus
or compromise. For a decentralized system to be intelligent there must be a
means of aggregating all members’ inputs such as market prices or centralized
decision makers, e.g., Linux. The risk of decentralization is that information
won’t make it through the system to where it is most valuable. There must be a
balance that allows individual knowledge to be specific and local (tacit) but
also makes it globally useful.

People focus better on a decision when there are financial
rewards attached to it so decision markets are often successful.

Examples

Problems can be classified as

• Cognition:
  when there are definitive solutions (Who will win the Super Bowl?) or
  there is a best possible answer (Where’s the best place to site this
  building?)
• Coordination:
  when members’ behavior must be coordinated (driving or finding a party)
• Cooperation:
  getting members to work together when self interest would dictate that
  they should not (taxes, dealing with pollution) 

For coordination problems, independence is pointless since
what one member is willing to do depends on what that member thinks other
members are going to do. The El Farol problem shows that even in this case
collective judgment can be good though it can result in many members not being
satisfied. With traffic jams the diversity of drivers makes coordination
difficult. Solution is more control: automatic highways with platoons of
synchronized cars or driver assistance to keep cars evenly spaced.

 Cultural conventions allow groups to organize without
conflict, e.g., “first come first served,” queues – there is wisdom in
conventions but many conventions can be very stupid. For example B movies and
old movies cost the same as new. This convention is uncoordinated with
moviegoers.

To solve cooperation problems, members need to adopt a
broader definition of self-interest than maximizing short-term profits and they
need to trust other members. There also needs to be a mechanism for preventing
free riders since many people are conditional consenters – only cooperating
because they believe that people who don’t will be punished. People exhibit
strong reciprocity: willingness to punish bad behavior even when they get no
material benefit. The evolution of capitalism has been toward more trust and
transparency because the benefits of trust are immense.

·       
Science:

o       People
still prefer to work in proximity to colleagues but researchers who spend more
time collaborating internationally are more productive.

o       Scientists
want recognition more than cash. We trust that allowing scientists to pursue
self-interest yields better results than command and control.

o       The
blend of collaboration and competition works because of open access to
information.

o       The
flaw is that most scientific work never gets noticed because famous authors get
read more

 
Rules for Small
Groups

Small groups can be good because they make people work
harder and think smarter. Non-polarized small groups make better decisions than
individuals. But small groups face many problems so there need to be rules for
good decision making

o       Discussions
must have structure (ask each member for input) but not too much (one leader
doing all the asking)

o       Decision
making must not begin with a conclusion. This makes it unlikely for new info to
be incorporated. Don’t spend all the time talking about what everyone
knows/agrees on

o       Devils
advocates must be encouraged

o       Groups
polarize through discussion (counter to common wisdom) because members try to
maintain their place in the idea spectrum relative to the entire group. So if
entire spectrum shifts right, member must shift right just to stay in the
middle. To avoid polarization make sure the group has equal number of people
with strongly opposed views.

o       The
order of speakers matters – earlier comments are more influential. So don’t
choose earliest speakers on basis of status since that may not equate to more
knowledgeable. The same applies to group members that talk the most.