Longtime readers are familiar with my views on prediction markets. I believe they have some value, when applied correctly. Where prediction markets excel is in acting as a collective real time polling mechanism for their participants. The closer the collective group is to the broader population, the more accurate these markets tend to be. Where they do poorly is when the collective attempt to “pool their ignorance” and forecast the random or the unknowable.

There is strength in any mechanism that can factor a large pool of participants collective experience and knowledge, discount several possibilities into the most likely outcome. These market mechanisms are hardly the Oracles of Delphi their supporters make them out to be. It is only by din of Humans’ even worse forecasting abilities (with experts leading the way down) that these markets garner so much respectability in the first place. Blame fuzzy thinking for placing too much credibility on a mechanism with so mixed a track record. There is also a subtle but important distinction between forecasting the future versus discounting various outcomes.

Which leads me to [the] New York Times column. In a bizarre twist of logic, the massive failure of the prediction markets in the US 2006 mid-term elections somehow gets credit for being right. They were not a day late and a dollar short, they were completely, totally and incontrovertibly wrong.

Except in the NY Times:

Consider the following: As of 11:50 p.m. on the evening of Election day, with the voting completed (except for Hawaii) and the majority of the ballots counted, Intrade gave the Republicans an 85 percent chance of retaining the Senate. Of course, we know that’s not at all what happened. If that’s not a forecasting failure, then what is?

If forecasting the results of an election held yesterday is considered prescience, then sign me up — and find me a bookie who will take my Superbowl bets on the Monday after the game. I suspect I will at least cover the spread.

To reiterate my views, these markets — thinly traded, easily manipulated, poorly administered — do have some real value. However, they have hardly been “remarkably clairvoyant,” as the Times describes them. Consider these recent acts of “clairvoyance:”

- GOP Retention of Senate
- Michael Jackson Trial Results
- Morgan Stanley CEO Purcell resignation
- Howard Dean’s Iowa Primary
- Pre-Election 2004
- Election day trading frenzy

There are some interesting explanations for some of these errors: Pooling the collective ignorance of millions does not produce Wisdom. The Michael Jackson Trial and Morgan Stanley’s CEO are perfect examples of that.

As to the prediction market’s failure of the Howard Dean primary and the 2006 mid-term elections, I’ve been toying with a theory. Since the political affiliation of Wall Street tends toward Republican, and since there is a big overlap between Wall Street and the participants of the prediction markets, the collective had an inherent bias built into it. Remember, where these markets excel is when they act as a realtime polling mechanism of their particpants. If the pool has a bias, the outcome may very well too. Hence, these widescale failures.

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Bottom line: While having value, prediction markets are subject to error and bad outcomes. Some of this is due to their relative thinness of the markets; some is due to the inherent biases of the participants, and their failure to parallel the population at large.

They should be considered with the recognition of their fallibility.

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Source:
Odds Are, They’ll Know ’08 Winner
DAVID LEONHARDT
New York Times, February 14, 2007
Economix

http://www.nytimes.com/2007/02/14/business/14leonhardt.html

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Cross-Posted from The Big Picture

According to Tradesports, the odds of the Republican Party retaining control of each Congressional House in the 2006 Mid Term Election is mixed.

In the Senate, only one third of the 100 seats are up for re-election. Votes are staggered, so every 2 years a different third of the 6-year term seats come up. The odds strongly favor GOP retention of the Senate. The Democrats would need to capture 6 seats, something previously viewed as rather unlikely — not impossible, but unlikely.

Although several races have tightened, this remains a long shot for the minority party. The MSM is, as always, focused on the horse races but not the issues. See Race for Senate control tightens for example.

When we go to the most recent betting on the outcomes, the senate appears to be rather safe. Using trend or technical analysis, we see the GOP retention of Senate has been consistently above 70%; It has recently dipped as Tennessee and Virginia — formerly “safe seats” — have become competitive. But it would take a significant break of 70 to suggest this was anything but a long-shot.

Senate Trading

via Tradesports

When it comes control of the House, however, the prediction markets present a very different picture. All 435 seats are up for grabs.

Its also one that lends itself even more to TA:

via Tradesports

From last November til today, we see a fairly well maintained down trend. Recently, that was almost reversed on an increase in volume since hitting lows of 40% in September. That was most likely the result of a 30% drop ingasoline prices, a 20+% in Crude Oil prices, and a strong post summer rally in the stock markets.

However, the Foley/Page scandal has now reversed that. On even bigger volume, the downtrend has been maintained, and the House odds are once again near low 40s.

If the election were held today, the Senate would stay GOP, while the House would shift to the Democrats.

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There is one additional note: I have long complained that the relative thinness of these markets — the number of traders and the dollar amounts at issue — can make their results somewhat suspect. For more on this, see our 2004 critique, Iowa and Prediction Markets.