How Brexit Caught Investors and Oddsmakers Off Guard

Brexit revealed the limits of the markets’ predictive powers.
Photo illustration by 731; Photos: Getty images (2)

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 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 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 London-based 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 best-selling 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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