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Posted at 10:04 AM ET, 01/03/2012

The Iowa Caucuses, dark horses and the mystery of crowds

The sun sets over a farm January 1, 2012 in Johnston, Iowa. (Win McNamee - GETTY IMAGES)

With less than 24 hours to go before the Iowa Caucuses, former Massachusetts governor Mitt Romney and Rep. Ron Paul (R-Texas) are are well positioned to finish first and second in the first voter test of the Republican field. That’s not just the consensus of pundits and armchair politicians — that’s the current outcome predicted by the Iowa Electronic Markets, perhaps the most avidly watched prediction market during any U.S. presidential election. Real traders with real money on the line, at the writing of this blog post, were giving Romney roughly an 86 percent probability, and Ron Paul around a 70 percent probability, of finishing in the top two when all the final results have been tallied by midnight.

Prediction markets, which burst into mainstream popularity after the release of James Surowiecki’s The Wisdom of Crowds, have become an increasingly sophisticated way to model the outcome of events when the range of possible outcomes is known. With less than 24 hours to go, the “crowd” appears to have written off Texas Governor Rick Perry and Rep. Michele Bachmann (R-Minn.) to the point where their contracts in the Iowa Electronic Markets are trading at close to zero. The crowd thinks that even former House speaker Newt Gingrich now has less than a 1 percent probability of finishing in the top two in Iowa — even after a surge in popularity at year-end.

Former Massachusetts governor Mitt Romney. (Justin Sullivan - GETTY IMAGES)
In fact, the only contract other than Romney or Paul that’s not worthless right now is a curious little contract called “ROF,” or “Rest of Field.” As the rules of the Iowa Electronic Markets point out, the ROF contract offers a way to bet on a “mystery candidate” who isn’t currently represented by any other contracts. With just 24 hours to go, ROF is trading at close to 40 cents, meaning that “the crowd” thinks that an unknown, mystery candidate not currently represented by an existing contract could turn the Iowa race upside down.

In other words, does the crowd now think that a dark horse challenger like Rick Santorum or Jon Huntsman has close to a 40 percent probability of finishing in the top two? Or, for that matter, a total unknown like Gary Johnson?

Theoretically, the ROF contract should trade for close to zero on most days, and then spike on days when dark horse challengers like Chris Christie or Sarah Palin are rumored to be gearing up for an election bid. For example, the ROF contract traded at close to 25 cents in September when it was rumored that Sarah Palin would join the Republican field.

So, what does it mean when dark horse challengers are still in the running and the crowd is still willing to place bets on them, even with seemingly impossible odds?

Republican presidential candidate Rep. Ron Paul (R-Texas). (Kevork Djansezian - GETTY IMAGES)
One clue might be to look at another contract that trades on the Iowa Electronic Markets: the 2012 Presidential Election Contract. Currently, the Republican presidential contract is trading at 50 cents and the Democrat presidential contract is trading at 52 cents. In other words, the crowd thinks that whoever wins the Republican nomination still has a less likely chance of becoming president than the Democratic candidate, President Barack Obama.

The crowd may sometimes be mad and delusional, and the Iowa Electronic Markets do not always get it right. But what’s interesting is that the Republicans continue to shuffle through candidate after candidate, looking for someone who can beat Obama head-to-head. According to the crowd, none of the current Republican candidates — at least not anyone who’s currently in the field — can. The 2012 Presidential election may be one of those epic horse races where the pundits get it all wrong, and the crowd gets it all right. Will a dark horse candidate come out of nowhere to win the race at the end by a nose?

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By  |  10:04 AM ET, 01/03/2012

Categories:  Dominic Basulto, Morning Read, Technology

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