At a client conference in my last job, one of the keynote speakers was writer James Surowiecki, author of the book The Wisdom of Crowds. Pulling notes from his book, he made a compelling case that large groups of people are smarter than an elite few, no matter how brilliant; better at fostering innovation, coming to wise decisions, and even predicting the future.

[photopress:crowds.jpg,full,alignright] The most fascinating example (and there were many) of this wisdom is in the investigation of a submarine that had sank and disappeared. The Navy had limited information regarding its location, and all searches came up empty. One smart fellow had the idea to consult a wide range of experts – in oceanography, ballistics, physics, engineering, etc., and ask them to come up with a probable location of the submarine. All the answers were collected and analyzed, and an ‘average’ location was charted based on the data. Chillingly, the sub was found within hundreds of yards of that location.

With large sample sizes, crowds form a network, and the best solutions bubble up from the collective thought. Though it sounds very Borg-like, we witness examples of it every day. The financial markets often sniff out trends and problems before they hit the front page. There is no collusion or any critical mass of explicit cooperation here – these trends are created by the cumulative wisdom of the market’s millions and millions of participants.

Which brings me to the potential wisdom of the Chicago Mercantile Exchange’s housing futures index created by Karl Case and Robert Shiller. Theoretically, this market would allow individual homeowners to hedge their investment by purchasing future contracts based on their metro level housing market. Let’s say I owned an apartment in NYC that is worth $1.5mm today. I could buy contracts that would pay me if the market dropped by 20%. I would effectively lock in a certain value for my property at a future date with these contracts.

If this concept takes off, the swings in the housing market would flatten considerably. If Joe homebuyer sees the contract prices that are based on next year’s housing values reflect a substantial drop, Joe homebuyer will be less likely to overpay for a property. Also, if Joe homebuyer could basically buy insurance against a large correction, the real economic impact of such corrections would be dampened by the payout of this ‘insurance’. However, Surowiecki has doubts that such a ‘wise crowd’ can materialize in the near future. As explained in a New Yorker article on this market, culture and habit matter as much as economic rationale. He writes:

“Even today, it’s clear that otherwise rational people harbor deep-seated beliefs that make housing futures a tough sell. People generally don’t hedge individual investments, because they don’t like to limit their potential gains in advance. That’s especially true when it comes to housing, because of the ingrained assumption that, over time, real estate is guaranteed to be an excellent investment—even though Shiller, in a recent book, shows that, allowing for inflation, American home prices barely budged during the twentieth century. In that sense, the housing-futures market has what is known as a framing problem: selling a contract seems like betting on housing prices to fall, rather than simply insuring yourself in case they do.”

This market debuted only about four months ago, so there is by no means any critical mass to it. It’s thinly traded, and it only offers futures on 10 US markets (Seattle is not one of them). Interestingly, the trading activity indicates a correction in the ten covered markets over the next year (with Denver showing the least downside). I would love to have had Seattle on the list. But, if trading activity increases, I would imagine that more markets would be added – and Seattle’s got to be high on that list.

Given that real estate is extremely localized (e.g. neighborhood by neighborhood), would a market that had critical mass (millions of contracts exchanged per day) be a driving force in the direction of a metropolitan market’s value? Would the average increase or decline be pretty darn close, even if street level values varied significantly block by block? My guess is that they would be extremely influential in how money moved in and out of the housing market. Such an efficient market would provide opportunity for long term homeowners to hedge their investments, speculators to make bets on the direction of the market, and renters to protect themselves from ‘missing out’ on appreciation.

In other words, many of the financial benefits of the American dream of homeownership could be had without ever buying a home. Take things a step further, and perhaps a fully matured and stable housing futures market would advance the dream of disintermediation further than Redfin or Housevalues could ever do. With good market info, long term home buyers wouldn’t have to worry so much about overpaying on a property if the market indicates a strong future value. Therefore, a precise valuation that an agent might be able to give versus that of an automated system may not worth the extra money it would cost in agent fees.