Over the years, I have been critical of prediction and futures markets. In particular, the specific ways certain parties misuse them (i.e., politics).

However, I am a big believer that markets can generate valuable economic and investing data that can be quite helpful when handled appropriately. In my own work, we rely on the 10 year interest rate as part of our overall economic modeling. On the equity side, we use various trend component for indices in addition to volume, money flow, short interest and institutional ownership for sectors and specific companies.

In each of these cases, we are relying on markets that are deep, diverse and trading in dollar volumes measured in trillions. This is part of my criticism about future markets: They are thin, trading volumes are anemic, the dollar amounts at risk are pitifully small. Thus, these markets are subject to failure at times.

Indeed, the excuse making for the failure of the futures market began almost as soon as the New Hampshire primary ended (see Why the Online Prediction Markets Blew New Hampshire, Prediction markets are forecasting tools of convenience that feed on advanced indicators, etc.)

None of these really looked at what makes futures markets work, how they can fail, and what their strengths and weaknesses are. This morning, I want to delve into some the problems these markets can have, why they fail, and what value they do offer.

First, Let’s start by reviewing some of the more spectacular prediction market failures:

Iowa Primary 2004 (Howard Dean vs everyone else)

2006 GOP Senate Retention

New Hampshire Primary 2008 (Obama vs Hillary)

In the area of politics, I am in agreement with Dan Gross, who wrote "these are less futures markets than immediate-past markets." In other words, bettors essentially aggregate polling data that is already out — rather than forecasting the unknown future.

When it comes to politics, its not as if the Iowa electronic market or Intrade gamblers have any special insight or inside knowledge. They don’t "know" anything — as individuals or collectively — that the rest of the public (insiders included) don’t already know. They’re all reading the same newspapers, blogs, polls, etc., and responding to whatever broad narrative happens to be coming out that day or week. They respond just as any other focus group would, off of the same information the electorate has.

I sometimes think of the political futures markets as a focus
group unto themselves. Here’s where things get really interesting:  When the group is
something less representative of the target market, they get it wrong
with alarming frequency. Indeed, the closer the traders are as a group to the target decision makers/voters,  the better their track record.

Consider smaller "electorates" beyond the political events mentioned above. Think of the Michael Jackson Trial, or the Morgan Stanley CEO Purcell resignation betting — these much smaller groups of 12 jurors, or a handful of MS directors don’t lend themselves very well to focus groups or polling. 

Hence, the lower success rate. 

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.

We see this especially in close elections: When they are similar to the voting electorate, they get it right; as they differ, their error rate goes up. This commonality to where they fail is one that’s worth exploring further by some suitable academic (Robin? Justin?)

A more academic way to analyze these issues is to look at what makes markets work. Lets go to Legg Mason’s Michael Mauboussin:

"The "wisdom of crowds" is a colloquial way of describing the market as a complex system. The work on wisdom of crowds shows that when certain conditions are met—diversity, aggregation, and incentives — markets tend to be efficient. Conversely, when one or more of those conditions  are violated, markets can and do become inefficient (i.e., price is no longer an unbiased reflection of value). 

For a host of social psychological and sociological reasons, diversity is the most likely condition to be violated. Here, too, market observers have recognized the importance of diversity. But what’s essential to recognize is the relationship between diversity breakdowns and asset price performance is nonlinear. Diversity can be on the decline as the asset price rises, which makes the market fragile. Like a rubber band that’s stretched, the tension builds and the inevitable snapback is often painful." 

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 we 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 many Wall Street economists: at times, they merely extrapolate the current trend forward. Hence, they can be right for most of a run — an economic expansion or stock bull market, etc.

However, this process leads them to completely miss major turning point, or an unexpected shift or event. I suspect this factor also played into the New Hampshire 2008 failure…

>

 

Sources:
Mauboussin on Strategy: Fat Tails and Nonlinearity
Diversity Breakdowns and Invisible Vulnerability.
Legg Mason Capital Management, DEC-20-2007
http://www.leggmason.com/individualinvestors/documents/insights/D4114-FatTailsNonlinearityLMIS.pdf

Bad Bet
Why were the political futures markets so wrong about Obama and Clinton?   


http://www.slate.com/id/2181745/

Category: Markets, Politics, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

25 Responses to “Why Prediction Markets Fail”

  1. lurker says:

    Where the markets are and have always been ruthlessly efficient? At separating fools from their money. Always have and always will.

  2. CaptiousNut says:

    I am sure people looked at nascent stock and bond markets decades ago and concluded that they “fail”.

  3. Brian says:

    Side note on food inflation:

    36 pack of local eggs in Sam’s Club
    - $3.87 October 2007
    - $6.07 January 2008

    Thankfully, I’m saving tons of $$$ because we’re replacing high priced oil with high priced, inefficient corn ethanol, wait a second…….that doesn’t sound right.

  4. michael schumacher says:

    ^^^^ sounds just like the fed when they got rid of the M3. “it’s just too costly”….as they redesigned it’s entire web site and launched it, coincidently, on a Fed release day.

    OT:
    ANyone else notice that MER “upgraded” BSC….
    with what MER sold to BSC it’s a little game of friends helping friends.

    Ciao
    MS

  5. michael schumacher says:

    where’d Stuart’s post go???

    Ciao
    MS

  6. Joe says:

    Have you seen this paper from some folks at Google who ran an internal prediction market at Google?

    http://services.google.com/blog_resources/google_prediction_market_paper.pdf

    Its worth a read. For a summary of highlights, check the Google blog.

    http://googleblog.blogspot.com/2008/01/flow-of-information-at-googleplex.html

  7. Stuart says:

    MS, Barry probably thought it was too long.. I sort of wondered about that too.

    Simplified: We knew this was coming. Banks pushing to change the accounting rules so they don’t have to absorb the losses.

    http://www.nytimes.com/2008/01/11/business/11norris.html?_r=2&ref=business&oref=slogin&oref=slogin

  8. dave says:

    Remember the Defense Dept. program called the Futures Markets Applied to Prediction (FutureMAP), that would have involved investors betting small amounts of money that a particular event — a terrorist attack or assassination — would happen?

    It was part of the Total Information Awareness program under retired Adm. John Poindexter…And was shotdown by Congress.
    [CNN - circa 2003]

  9. michael schumacher says:

    crossed bids on gold this morning….

    Gold about to break out over 900…..IMO

    Ciao
    MS

  10. Ross says:

    Corn, lock limit UP! This is starting to look serious. Export controls from China and others.

    I’d start hoarding sugar for a good run from here. If I’m wrong, build a still…

  11. Loren Steffy says:

    BizLinks | 1.11.08

    Bank of America to Acquire Countrywide for $4 Billion — and another failed CEO gets another nine-figure send off. Consumer confidence slips to record low Conoco in Lead for Abu Dhabi Deal ($) Banks Plead They Can’t Follow Rules…

  12. 2and20 says:

    yeah the markets on intrade are pretty thin, for example only around $20,000 has been risked on the US Recession 2008 bet, and the current bid/offer size on it just now is only around $50!!

    having said that, the market is what the market is. if you disagree with the price, you can always go and trade on it.

    there will always be surprises in any “bet”, the only way to say if the prediction markets get it wrong is to look at ALL markets they’ve had, what was the price before the event, and what was the outcome. I bet you’ll find that it all fits a nice smooth curve, whereby 10 to 1 shots happen about 10% of the time etc.

    just cos a 10-to-1 bet comes in doesn’t mean the market is wrong. it’s just probability.

  13. Greg0658 says:

    I would like to see a headline article on costs of living around the developing world.
    I’m wondering when the billion new capitalist consumers will have the cash to fill the shoes of the faulting American consumer.

    When I hear stories like 15% of a products manufacturing cost stay with the manufacturing country like China, I’m wondering when they (foreign workers) are up to speed to buy American, even with our devalued dollar.

    Seems we (USA) are in that horrific spot of mass revalue’g to seek equilibrium with the flood of foreign labor and manufacturing.

  14. VJ says:

    Speaking of Dan Gross, he was mopping the floor with Wall Street Journal‘s Stephen Moore in a debate on the Lehrer News Hour yesterday. My favorite exchange:

    STEPHEN MOORE: Well, you know, it’s funny you should ask about that, because I’ve been looking very closely at the economic policies of the Republicans … They’re all saying they want to make the Bush tax cuts permanent, which I think is really important for the economy. They’re all saying that they don’t want to raise taxes.

    Whereas, on the Democratic side, virtually all the Democratic candidates, Obama, Hillary and Edwards, are all saying, playing I think what you might call the class warfare line, which is, “We’re going to raise taxes on the rich, give more money to the middle class.”

    That didn’t work for George McGovern or Mondale. Let’s see if it works this time.

    DANIEL GROSS: Well, certainly it worked for Clinton in ’92, raising taxes on the wealthy.

    LEHRER LINK

    Of course, to be fair, debating the consistently loony Moore is like shootin’ fish in a barrel.
    .

  15. Alfred says:

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    Alfred

  16. Byrne says:

    Your criticism has already been addressed (and translated): your problem with prediction markets is that it would be profitable to be a market-maker in one of them.

    Is there any valid criticism of prediction markets that isn’t an implicit trading strategy?

  17. Daltica says:

    Hi!

    You said, “However, I am a big believer that markets can generate valuable economic and investing data that can be quite helpful when handled appropriately.”

    This remind me of an article, Why is the market so easily tossed and turned by dribs and drabs of data?:

    Notice one thing: the market is trying to absorb every piece of economic data (e.g. unemployment level, manufacturing index, GDP, CPI, etc.) and still yet not able to make up its mind on what is happening to the US economy. Given that many highly esteemed economists and analysts have conflicting opinions, how can investors and traders make confident decisions?

    These are good questions. Why is there so much confusion?

    To answer this question, we will turn to a rare, most hard to find, most buried important book, in the history of the Austrian School of economic thought: Crises & Cycles by Wilhelm Röpk. This book was originally written in German and was published in 1936. In Chapter 4 of this book, “The Causes of Crisis and Cycles,” Röpk wrote,

    Very very appropriate for our times!

    Yes, I agree with you that if all these data are handled properly, they can be quite useful. Unfortunately, they aren’t and the question of accuracy of these data comes into consideration as well.

  18. RT says:

    Barry, you and others are completely off-base on this, and do not understand probability theory:

    http://amitghate.blogspot.com/2008/01/probabilities-prediction-markets-and.html

  19. RT says:

    Barry, you and others are completely off-base on this, and do not understand probability theory:

    http://amitghate.blogspot.com/2008/01/probabilities-prediction-markets-and.html

  20. Jason says:

    If prediction markets worked 100% we’d all get rich investing with that knowledge. Instead, you need to interpret the data — creating an uncertainty but source of valuable information. I’ve learned quite a bit about this while developing SodaHead.com, which we originally planned as a quasi-prediction marketplace.

  21. mickslam says:

    I would guess there are no hedgers in these markets. In other words, there is no party with a view to the long term value of the trading vehicle. Only speculators are participating. Lets say the lack of dumb money means the smart money doesn’t show up.

    We can assume that these markets are still far too small to measure anything of value in any case. I haven’t looked lately, but I would imagine there is only a few million dollars at risk maximum. Who cares about this much money spread out over 10 candidates? Nobody looking to make real money.

    Markets are horrible predictors in cases where there is significant money at risk. We can see this in the current credit crisis, that was NOT predicted by prices or markets at all, despite lots of warnings. Here is a case where the global economy is facing significant risk, where there were 10′s if not hundreds of billions (with a B) to be made for being right, and still the markets didn’t see it coming.

    Markets are interesting in that they show the current prevailing wisdom quite clearly.

  22. RT says:

    Barry: my reply to your comment here:

    *************************************
    Au contraire, I specifically said prediction market can be proven wrong, but not by reference to a single event.

    For example, the probability of rolling a ’5′ on a six-sided die is 1 out of 6, or a 16.667% probability. That’s a low probability. However, eventually I will throw a 5. When that happens, would you then call the 16.67% probability “wrong” — because the “unexpected” happened? Of course not. We know for a fact that the probability is exactly 1 out of 6.

    The only way to prove that the probability is wrong — i.e. *not* 1 out of 6 (e.g. if we suspect the die is loaded) — is to throw the die hundreds of times and confirm whether the frequency of a ’5′ does indeed occur 1 out of 6 times.

    Same with prediction markets. If you want to prove that they are ‘wrong’ or ‘inefficient’, you need to look at the frequency of results over time, relative to their predicted probabilities.

    I have no dog in this fight, such a study could very well prove that prediction markets generally assign incorrect probabilities. But you can’t tell that from a single event.

  23. Me Media: Prediction Markets in the NYT

    (Apologies to Paul for stealing the headline) Last month, we took a look at Why Prediction Markets Fail, reviewing some of the more blatant misses. That theme was picked up in a longer NY Times piece today, titled, Looking for Sure Political Bets at On…

  24. Ed says:

    Las Vegas runs predictions markets every Sunday during the NFL season. For the most part, the teams that get the most action don’t cover the spread. Another prediction market failure.