I'm a proponent of prediction markets. It seems obvious to me that if you want to know what smart people know, the way to do it is to pay them in proportion to their ability to make good predictions. We already do this in an ad hoc sense -- people who make the right investments and career choices make more money -- but formalizing it can't hurt. Most of the people who discuss this seem opposed to prediction markets, though. Fortunately, I can usually address their claims on my terms:
- Prediction markets are too easy to manipulate seems to mean "I could consistently make money betting against suspiciously high-priced 'establishment' candidates on political betting markets. This would bring prices closer to reality, and make me richer, too!"
- Prediction markets aren't liquid enough to be accurate implies "It would be profitable to be a market-maker in a prediction market, because the bid/ask spread is so high."
- They give really weird results says "Despite these high spreads, there are arbitrage opportunities."1
- Prediction markets are less accurate than polls also means "I can bet that prediction market results will revert to poll results, and automatically make money."
- Prediction markets are only as accurate as polls, on average means "I don't understand sampling, and think that two measures of the same variable with the same accuracy, when averaged together, are just as accurate as one. I can use this to empirically prove that you can always survey one less person in your polls, and still be just as accurate."
- Prediction markets will help terrorists make money from assassinations implies that "terrorists would rather make $5,000 dollars on a 90-point jump in an assassination contract than many millions of dollars using derivatives to short the broader market in advance of market-disrupting action." You'd need a multi-billion dollar prediction market in airline-based terrorism for it to make more sense to bet on the prediction market rather than buying puts on airlines before 9/11, for example.
That covers it, I think. On the other hand: Daniel Dennett can explain Christianity as a Darwinian phenomenon involving the cost of acquiring new information versus mimicking people around you. His opponents can explain him as a religious phenomenon involving the necessity of doubt to make faith meaningful, or the temptations of a materialist outlook. In other words, I'm sure there's an anti-PM system of thought in which my examples are nonsense. I just have no idea what it might be: in every example, I've explained how a market skeptic who really believes in market skepticism can make money at the expense of radical, fundamentalist free-market demagogues like me. Is there a counterargument?
[1] The Al Gore arbitrage mentioned in that article is over: whoever shorted the Gore-President and bought the Gore-Nomination made a low-risk profit.
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Comments (3)
Well, I'm a person that uses markets in part for their future discounting mechanism (a smarter phrase than predict);
I have legitimate criticisms of when and how the prediction markets fail. (http://bigpicture.typepad.com/comments/2008/01/prediction-mark.html)
I am not opposed to prediction markets -- but I do think it is a worthwhile exercise to identify what their flaws are, and how they occasionally fail.
And if we can avoid deifying them, even better . . .
Posted by Barry Ritholtz | January 11, 2008 6:05 PM
Posted on January 11, 2008 18:05
If you're using those much deeper markets, you're essentially arbitraging different views of the future (the future view implied by treasuries versus the future view implied by S&P earnings yield, for example). That's a legitimate way to trade, but it's not the only way to trade: if you'd been doing the same strategizing 25 years ago with MBSs, you would have gotten a pretty crazy model because the spreads were ridiculous and the quotes didn't mean anything. This might have been a hint that people like Ranieri would make a killing. Similarly, if you were involved in distressed debt before that, you might have noticed that this Milken guy was earning something like 100% on capital every year just making markets, and more on top of that with directional trades.
The problem is that you're extending your personal problem (the market is too shallow for you to rely on it, but too small for you to profitably make a market) to everyone else. Most of your readers probably have just the right bankroll for taking either side of a PM trade and pocketing the bid/ask spread. You could have written an entry about how the New Hampshire results demonstrated the 30-to-1 overnight return people got from buying Hillary, or the huge profits an attentive day-trader could earn taking either side of a transaction -- but instead you focused on how it wasn't the right market for you, and generalized this to claim that it isn't a useful market.
I could easily say the same kind of thing about the information-saturated, heavily traded equities market, too: it's not the right place for someone who wants to trade full-time and make 10% or so on each side of a $100 transaction. But it would be ridiculous for me to identify that as a flaw rather than a feature.
It is worthwhile to identify flaws in prediction markets, but as my post hopefully showed, these flaws can be profitably corrected.
I don't really understand how it's 'deifying' to address ill-considered criticisms. And it's not just unfair -- it's incoherent: don't call a PM a god when you could call it an oracle.
Posted by Byrne | January 11, 2008 6:35 PM
Posted on January 11, 2008 18:35
In my own work, we "use" markets in several other ways:
We rely on the 10 year interest rate as part of our overall economic modeling. Combined with other data, the yield (and more importantly, its trend and directional movement) can provide some insight into inflation and growth.
On the equity side, we use various trend components for indices (ST, IT, LT) in addition to volume, money flow, short interest and institutional ownership for sectors and specific companies.
There's lot of data and insight that markets provide, but it requires them to be very deep and broad. In our experience, the less so, the less reliable they are.
Posted by Barry Ritholtz | January 11, 2008 10:07 PM
Posted on January 11, 2008 22:07