Barry Ritholtz blames the New Hampshire fiasco on two Red Herrings.

Barry Ritholtz promised; he delivers.

[...] Back to political futures: I suspect the traders at Intrade in 2006 missed the GOP Senate loss, because as a group, they themselves skewed away from the rest of the nation. The demographics of Intrade traders are likely higher income, better educated, leaning more GOP than the USA as a whole. Hence, the variation of this focus group away from the larger electorate led to the bad forecasts there. [...]

Hence, we see more potential sources of market failure as these conditions are violated:
1) An insufficient amount of incentives;
2) A lack of diversity of ideas;

We’ve discussed both of these, albeit in less than academic terms: The small thinly traded markets means the money at risk is rather small — measured in $1000s, not trillions of dollars. Hence, the incentive is minimal — or perhaps non-monetary. Maybe this attracts a somewhat more politically passionate — and less objective — group of traders.

That can lead to a lack of intellectual diversity. As Mauboussin discussed, that is the most likely source of market failure. And as I review above, this is particularly acute when it comes to smaller groups not paralleling the demographics and or politics of Futures markets’ traders.

In some ways, Futures markets are similar to most economists: at times, they merely extrapolate the current trend forward. Hence, they can be right for most of a run — an expansion, bull market, etc. However, this process leads then to completely miss major turning point, or an unexpected shift or event. I suspect this factor also played into the New Hampshire 2008 failure…

The rebuttal is easy:

1. Economists Justin Wolfers and Eric Ziztwewitz wrote that, even small, compared to the financial markets, many real-money prediction markets are liquid enough to generate statistically accurate probabilistic predictions.
2. Academic papers have shown that IEM’s predictions have been slightly better than the polls, even though their traders are unrepresentative of the general US population.

Previously: Who did best in explaining the prediction markets to the lynching crowd?