How Brexit Caught Investors and Oddsmakers Off Guard
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 didnt foresee was that the Brits in the cheap seatsmost of whom dont own stockswere serious about rejecting the status quo. The fact that markets didnt 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 thats available to them. The more inputs, the better the forecast. In that way, markets are semi-efficient, 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 countrys economy, given the abundance of hard data thats 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 London-based Ladbrokes, one of the top bookmakers in the U.K., addressed the discrepancy in a June 24 blog post. Bookies dont 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).
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http://www.bloomberg.com/news/articles/2016-07-01/how-brexit-caught-investors-and-oddsmakers-off-guard