Prediction Markets 101 – Chapter One: Interpreting The Probabilistic Predictions


Probabilities, Prediction Markets, and Popular Fallacies

With Hillary&#8217-s surprise victory over Obama in the New Hampshire primary, pundits everywhere are decrying the allegedly &#8216-wrong&#8217- odds that prediction markets like Intrade were displaying prior to the announced results. (As just one example, Barry Ritholtz weighs in with his &#8216-explanation&#8217- of : &#8220-Why Opinion Markets Fail&#8220-.)

At one point the betting markets were implying over a 90% probability for Obama to win. Does this mean they were &#8216-wrong&#8217-? No it does not. It is impossible to judge whether a given probability is/was correct based on the outcome of a single event.

A 90% probability simply implies that, if you encounter a series of events each with a 90% probability, then 9 times out of 10, the favored outcome will occur- and 1 time out of 10, the unfavored outcome will occur. Those like Ritholtz who are now calling the prediction markets &#8216-wrong&#8217- are implying the following: if the probability is 90% for an outcome to occur, then that outcome should occur every time. In other words, if the odds are 90% in favor of something &#8212- it should happen 100% of the time! But this is obviously fallacious. If the outcome occurs 100% of the time, then the correct probability to assign to it would be 100% &#8212- not 90%.

To validly assess the accuracy of prediction markets, one needs to aggregate all the situations where the odds were 90%, and then calculate whether the favored outcome indeed occurred 90% of the time. (And do the same with each level of probability.) This &#8212- and only this &#8212- will tell you how accurate prediction markets tend to be.

Barry Ritholtz:

As every good prognosticator knows, if you couch your forecasts in probabilities, the innumeric will never know you were wrong. It&#8217-s a cheap trick for the easily fooled.

Imagine if instead of a &#8220-THE END IS NEAR&#8221- sign, every loon carried a sign that proclaimed:


The fact that this didn&#8217-t happen &#8212- and the 43% probability did &#8212- doesn&#8217-t mean this forecast was accurate. It merely meant that the person had proferred two possibilities and one of those two occurred. But the math remains unverified.

Neat trick: By your definition, PREDICTION MARKETS CAN NEVER BE WRONG, so long as they maintain a 1% possibility of the alternative outcome.

That&#8217-s hardly a satisfying defense&#8230-

Author Profile&nbsp-Editor and Publisher of Midas Oracle .ORG .NET .COM &#8212- Chris Masse&#8217-s mugshot &#8212- Contact Chris Masse &#8212- Chris Masse&#8217-s LinkedIn profile &#8212- Chris Masse&#8217-s FaceBook profile &#8212- Chris Masse&#8217-s Google profile &#8212- Sophia-Antipolis, France, E.U. Read more from this author&#8230-

Read the previous blog posts by Chris. F. Masse:

  • Good news: The BetFair blog now features a prediction market column. — Bad news: Their columnist is an anonymous writer with long hair… and dubious skills.
  • Once again, a BetFair spin doctor misunderstands the prediction market approach.
  • Grandizer
  • Tss… Tss… Surely, you are joking Doctor Giberson.
  • Comments are still open on Midas Oracle.
  • “I am much more aligned with InTrade than you are, Chris.”
  • And the award for the most technology advanced software vendor goes to… the envelope, please…. QMARKETS in Israel. … [Cheers and applauses in the crowd.]