Five Reasons the Prediction Market Critics Are Wrong.

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1. It really was an upset – As it has been pointed out elsewhere, the Clinton victory was a surprise to everyone. Favorites can lose. But so what? Ordinarily, that’s not a market flaw or a reason to doubt the odds shown in the market.

Justin Wolfers article in the WSJ had the best summary:

Against this background, it is no exaggeration to term the result truly historic. Not that there haven&#8217-t been more dramatic upsets or come-from-behind wins that carried more significance &#8212- this was just an early primary, albeit a pivotal one. But in terms of unpredictability, or at least the failure of everyone to predict it, it may have no modern match.

Historical comparisons are already being drawn between the New Hampshire primary and the famous 1948 presidential race…Yet the magnitude of the Clinton surprise is arguably even greater&#8230-Thus, Sen. Clinton&#8217-s victory on Tuesday was more surprising than President Truman&#8217-s in 1948.

Given the above, were the Clinton prices on Intrade very far off? It&#8217-s not obvious that they were.

2. Pundits/Critics are NOT traders – If I believe a contract should be trading around 30 and I see it trading at 7, it would make my day. As a trader, seeing a contract that is clearly mispriced is a good thing. Traders who remember the French politician Le Pen’s strong showing in 2002 vs his polls or who read Steve Sailer’s blog should not be surprised that people are dishonest with pollsters. However, to a pundit, an isolated incident of mispricing means the entire concept of prediction markets is faulty.

Since NH results, pundits have been asking, “Are prediction markets flawed?” The traders who make and move the market don’t believe so- they are trading more than ever. In any case, there were no postings on the 7th of January about how wrong the prediction markets are, only after-the-fact postings demonstrating perfect 20/20 hindsight. Traders, not critics, will determine the success of the prediction markets.

Let us not forget that pundits have an agenda too. For some, especially political ones, they need to present themselves as being able to offer insight that no one else has. Since prediction markets allow events to be quantified in real time, the pundits have less to add. This makes critics especially eager to take some of the shine off prediction markets and make themselves look smarter by comparison.

Additionally, there is a contingent of commentators and bloggers with an anti-market bias who delight in seeing any market based tool be wrong. They will be the first to loudly smear PM errors but no where to be found when the market turns out to be right.

3. PMs are not polls – This common mistake is exemplified by this quote from the Chicago Tribune, “The New Hampshire primary was a reminder that prediction markets, where bettors are putting money on the line, can have no more value than opinion polls, where participation costs nothing.” This critic missed the point and doesn&#8217-t realize he is comparing apples and oranges.

Most commentators have focused on the accuracy of the market prices without touching on the underlying purpose of the market: speculation and hedging. Even if the polls are no more accurate than the market, they still can’t be used for trading functions.

4. Regulations have hurt the accuracy and liquidity of PMs – The inconvenience of opening a trading account at Intrade has excluded many Americans from participating. What is the cost of accuracy to the PMs? Surowiecki’s The Wisdom of Crowds lists four factors necessary for a wise crowd: diversity of opinion, independence, decentralization, and aggregation. At least two of these have been highly restricted due to regulations. Even so, the market is usually more accurate than the polls. None of the critics has pointed out that with so many potential traders cut off from trading, the market is surely excluding informed participants.

5. “Serious people who study or work with these markets are not in the &#8216-markets are magic&#8217- camp” – Prediction markets are like other financial markets: fat tails, black swans, bubbles, “manipulations” etc. These are all visible in housing, equities, and fixed income markets as well and no one speculates about the end of those instruments. As Eric Zitzewitz pointed out, the “markets are magic” crowd is just a strawman and not a logical basis to attack prediction markets.

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3 thoughts on “Five Reasons the Prediction Market Critics Are Wrong.

  1. Niall O'Connor said:

    1. “Given the above, were the Clinton prices on Intrade very far off? It’s not obvious that they were.”

    That depends – what prices are you talking about. When Obama traded at a probability of 99%?

    2. “In any case, there were no postings on the 7th of January about how wrong the prediction markets (were)..”

    Indeed, because nobody had nay idea what was going to happen?

    3 “Additionally, there is a contingent of commentators and bloggers with an anti-market bias who delight in seeing any market based tool be wrong. They will be the first to loudly smear PM errors but no where to be found when the market turns out to be right.”

    Perhaps; but there also those of us who love markets, but who despair at the prediction market hype. For example, the bombastic claims that every time an event with a probability greater than 50% comes good …the market has somehow predicted it……..but when an event with a probability of 99% goes badly wrong …silence, followed by defensiveness.

    4. “PMs are not polls ..”

    Indeed, so why do some prediction market devotees waste time comparing them. And why is it that said prediction market devotees then turn a blind eye to a paper by Robert S. Erikson and Christopher Wlezien entitled “Are Political Markets Really Superior to Polls as Election Predictors? The authors argue that as prediction market prices reflect forecasts of what will happen on Election Day and trial-heat polls only register preferences on the day of the poll, it is inappropriate to naively compare them on any given day in advance of an election. Transforming raw poll vote divisions into projections of the Election Day outcome and comparing these projections to vote-share prices they found that daily poll projections are infact superior to IEM prices. Indeed, in three of the five presidential elections with IEM vote share markets, poll projections were more accurate than betting market prices. In four of the five elections (with one tie), the week’s average poll projection dominated the daily market price; “We have learned, however, that prices in the IEM vote share market are no better, and in fact a bit worse, at predicting the vote than are projections based on the day’s most recent polls”.

    Where the market holds to a view of the election at odds with the poll projections, it is somewhat more likely to be wrong than right”. The authors conclude that by their tests the IEM prediction markets are not better than trial-heat polls for predicting elections. In fact, they say, by a reasonable as opposed to naive reading of the polls, the polls dominate the markets as an election forecaster; “The Iowa election market’s performance has not been so special after all. For now, our results suggest the need for much more caution and less naive cheerleading about election markets on the part of prediction market advocates”.

    5 “Regulations have hurt the accuracy and liquidity of PMs – The inconvenience of opening a trading account at Intrade has excluded many Americans from participating.”

    The UK example, would suggest that this is in fact not the case. Whilst everybody is free to trade in Betfair’s political betting markets, few actually chose to do so.

    6 “Serious people who study or work with these markets are not in the “markets are magic” camp”

    Ok; fair enough – perhaps it is time to drop the word prediction then…..

  2. Jason Ruspini said:

    Regarding Steven’s point #4, consider that the way most Americans fund their accounts at this point is through bank wires, but last I checked at my bank these were $40 each way. So to fund a new account at the minimum level, you’re looking at a ~30% loss! The certainly weeds out many members of the crowd.

    Niall’s point #5 is of course valid. Just because people can access these markets doesn’t mean they will trade them. But to make the point complete, he should name some egregious PM failures in local UK politics. In any case, to get a fair test, people do need to be able to access the markets.

  3. The Data Mine Shaft » Blog Archives » "Predictions Are Often Wrong, Especially About the Future" said:

    […] Hampshire Democratic primary, Intrade’s political markets were off the mark too. Still, it may not have been Intrade’s fault that the markets were so off-base for so long, since there may have been other factors at work. […]

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