Brexit re­vealed the lim­its of the mar­kets’ pre­dic­tive pow­ers

How Brexit caught in­vestors and odd­s­mak­ers off guard “Mar­kets aren’t per­fect, but ev­ery­thing else is worse”

Bloomberg Businessweek (Asia) - - CONTENTS - −Kather­ine Bur­ton

A Lon­don-based in­vestor was on an air­plane head­ing home on the night of June 23 when the pi­lot an­nounced that the U.K. had voted to exit the Euro­pean Union. Cheers went up in the back of the plane. The pas­sen­gers sit­ting around him in busi­ness class groaned.

The dif­fer­ence in re­ac­tion might well ex­plain why mar­kets got it so wrong in pre­dict­ing a Re­main vic­tory. Traders and in­vestors were so con­fi­dent about vot­ers’ in­ten­tions to stay that they bought global stocks in the week head­ing into the Brexit vote, driv­ing up equity prices. On the day of the ref­er­en­dum, they sent the value of the Bri­tish pound up to $1.50, its high­est level of the year. What they didn’t fore­see was that the Brits in the cheap seats—most of whom don’t own stocks—were se­ri­ous about re­ject­ing the sta­tus quo. The fact that mar­kets didn’t ac­cu­rately re­flect that sen­ti­ment cuts to the heart of why they are im­per­fect pre­dic­tors of the fu­ture, es­pe­cially when it comes to po­lit­i­cal events like Brexit.

Mar­kets are only as ac­cu­rate as the in­for­ma­tion that’s avail­able to them. The more in­puts, the bet­ter the fore­cast. In that way, “mar­kets are semief­fi­cient,” says No­bel lau­re­ate and Amer­i­can Eco­nomic As­so­ci­a­tion Pres­i­dent Robert Shiller. They work bet­ter at pre­dict­ing the fu­ture value of a com­pany or the growth rate of a coun­try’s econ­omy, given the abun­dance of hard data that’s avail­able.

In the case of Brexit, there were es­sen­tially two sources of in­for­ma­tion: polls and odd­s­mak­ers. Both were in flux through­out. In opinion polls, Leave never reached 50 per­cent sup­port. Bet­ting odds of a Re­main win fell to 60 per­cent a week prior to the ref­er­en­dum, be­fore climb­ing to 90 per­cent as late as the evening of the vote. In the end, the in­for­ma­tion avail­able to both sources was im­per­fect, or at least in­com­plete. Poll­sters mis­cal­cu­lated turnout. In­vestors mis­took high odds at the book­mak­ers for cer­tainty.

They also mis­took the bet­ting mar­kets as a proxy for ac­cu­rate polling, in­stead of what they re­ally

were: echo chambers of broader fi­nan­cial mar­kets. Matthew Shad­dick, head of po­lit­i­cal bet­ting at Lon­don­based Lad­brokes, one of the top book­mak­ers in the U.K., ad­dressed the dis­crep­ancy in a June 24 blog post. Book­ies don’t post odds to help peo­ple pre­dict out­comes, Shad­dick ar­gued. “We do it to turn a profit (or at least not lose too much) and in that re­spect, this vote worked out very well for us.” Lad­brokes and other odd­s­mak­ers make money by set­ting the odds in a way that the amount of money they col­lect on both sides is equal. They then charge bet­tors a small pre­mium to cre­ate a mar­gin of safety (and profit).

While the ma­jor­ity of bet­tors were ac­tu­ally back­ing the Leave camp, that didn’t di­rectly trans­late into a shift in the odds. That’s be­cause what counts in bet­ting mar­kets is the amount of money that’s wa­gered, not the num­ber of peo­ple plac­ing bets. As Shad­dick points out, one £10,000 bet counts the same as 10,000 sep­a­rate £1 bets. “In an event like this,” he writes, “where the bet­tors are also par­tic­i­pants, (in that most of them were also vot­ers), should we have taken ac­count of that? We didn’t think so, but per­haps we were wrong.”

While the Brexit ex­pe­ri­ence puts the pre­dic­tive na­ture of mar­kets in a less-than-flat­ter­ing light, there are those who haven’t lost faith. “Mar­kets aren’t per­fect, but ev­ery­thing else is worse,” says Justin Wolfers, an econ­o­mist and pub­lic pol­icy pro­fes­sor at the Univer­sity of Michi­gan. Based on the sta­tis­ti­cal anal­y­sis of hun­dreds of elec­tion out­comes, the mar­ket is right more of­ten than it’s wrong, says Wolfers. “Brexit doesn’t fal­sify that,” he says. In Brexit’s case, ac­cord­ing to Lad­brokes, by the time polls closed, there was a 1 in 12 chance that peo­ple would vote to leave. Sometimes you hit the 1.

While there was cer­tainly a fair amount of trad­ing that took place in an at­tempt to profit off the Brexit vote, plenty of money man­agers steer clear of ex­po­sure to such events. “Mak­ing a bet on a dis­crete event, you are ei­ther right or wrong,” says Ben Inker, who co-heads as­set al­lo­ca­tion at Bos­ton-based value shop GMO. “I don’t know how you learn to do it bet­ter or even know whether you have skill at it or not.”

As wrong as they were in the runup to Brexit, it ap­pears that mar­kets over­re­acted im­me­di­ately af­ter. The two-day sell­off in stocks and the rush to havens such as gold and U.S. Trea­suries were purely psy­cho­log­i­cal, says Shiller. “The mar­ket gy­ra­tions af­ter Brexit re­flect hu­man na­ture. Mar­kets are not a spec­u­la­tive orgy. They are ir­ra­tionally ex­u­ber­ant,” he says, with a nod to the ti­tle of his best­selling book. “We all know peo­ple who are pas­sion­ate about a sub­ject, and they have all their facts and fig­ures— but they are also a lit­tle bit out of touch.” Or in this case, a lot.

The bot­tom line The Brexit vote calls into ques­tion how much faith we should put in the abil­ity of mar­kets to pre­dict the fu­ture.

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