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There are several fundamental problems with prediction markets: 1) Every market participant is not a savvy investor. InTrade was notorious for political bias a

by hooande 13y ago

There are several fundamental problems with prediction markets: 1) Every market participant is not a savvy investor. InTrade was notorious for political bias and emotional trading (check out the comment section). The idea is that a true insider will place a large bet that provides valuable information to the market. This is rarely the case. Most of the people bet based on what they want to happen rather than what they know will happen. [1] This problem is compounded by the fact that most of the bets on intrade in particular were rather small, hundreds of dollars. People tend to speak more accurately with their wallets as opposed to their mouths, but only with significant amounts of money on the line. 2) The markets themselves are never large enough. The system doesn't work unless the people that place big bets are experts or insiders. The majority of people aren't familiar with the concept of prediction markets, much less any particular sites. One of the best cases for an information market would be someone who works on a political campaign placing a big bet for or against their candidate based on inside knowledge. But something like this can't happen until the average political staffer has heard of a prediction market site, which we are still a long way away from. 3) The best way to make money from a market is to out think the other participants. Accurately calculating prices based on the current supply and demand situation works too, but it's slower and more difficult. Instead of asking "Who do I think will be elected president?" people might themselves "Who do the other participants think will be elected president?" This leads to a functioning market but it doesn't do much for the goal of aggregating knowledge to make accurate predictions. I like the concept of prediction markets because I love the idea of utilizing collective intelligence. But I'm constantly disappointed by the implementations that I see. It's a very tricky thing to do but I think that whoever finally figures it out will have built something valuable for all of us. [1] http://go.bloomberg.com/political-capital/2012-06-29/intrade-bettors-lost-on-health-care/ http://go.bloomberg.com/political-capital/2012-06-29/intrade...

l1ghtm4n 13y ago
All very good points. I had worked some years ago on a prediction market site which attempted to merge 3 mechanisms for gaining collective intelligence: Polling, paramutual betting, and full buy/sell market. It was motived by the fact that full blown market simulations are a steep learning curve for the non-investor, but that person has a valuable opinion nonetheless. Never did much with it.
_delirium 13y ago
One added wrinkle is that some people may have a positive incentive to make inaccurate bets, if they have something riding on the perception of the outcome, that's sufficiently important to them to be worth spending the money pumping up the perception. Whether that's feasible depends on the size of the market, but if InTrade drives even some of the news cycle, and if $100k can move the InTrade needle on a relevant issue, then blowing $100k on it is essentially advertising spend, an attempt at image-boosting.
- LanceH 13y ago
  The issues do muddy the waters for using them as prediction markets. It is awesome, however for the savvy investor. My experience has been they are far, far more accurate than the media. It is the nature of the accuracy that is interesting, however. They come to decisions well in advance of the media -- weeks or even months early. A good example would be this last national election cycle, the prediction markets had Rick Perry and Michelle Bachman virtually closed out while their media coverage was still treating them as viable candidates. They aren't always right in the long run, but they converge on the right answers much sooner than anything else I've seen, Nate Silver's efforts included. The biggest problem is that in the US they are either illegal (deemed to be gambling) or just too small (IEM).
- gwern 13y ago
  > but if InTrade drives even some of the news cycle, and if $100k can move the InTrade needle on a relevant issue, then blowing $100k on it is essentially advertising spend, an attempt at image-boosting. True. Little enough good it did the Romney whale on election day, though: he handed $4m as a gift to all the other Intrade users, and it didn't move the needle anywhere.
javert 13y ago
Your initial thesis is not supported by your observations, which anyway are problematic. (1) This is not a "fundamental problem." Not every participant in the NYSE is a savvy investor, either. (2) This was also true of the automobile market. It didn't stop Henry Ford. This is a serious incidental problem, but not a fundamental one. (3) The best way to make money in a prediction market is to be able to predict the outcome of the predictions. You can also try to do what you're suggesting, and may have some success. Anyway, the evidence is that prediction markets work, both for hedging and for knowledge prediction.
- pdonis 13y ago
  The best way to make money in a prediction market is to be able to predict the outcome of the predictions. I don't think this says quite what you meant. :-) As it stands, it can be read as saying that you can make money by predicting what other people believe, which is in agreement with the parent's #3. (And which is also true--as I noted just upthread, the author of the article in the OP did exactly that by buying and then selling McCain bets for the 2008 election.)
  - javert 13y ago
    This is a pointless nit pick, but two can play at that game. The outcome of the predictions is that all the correct predictions resolve to 1 (or 100% or what have you) and all the incorrect predictions resolve to 0. Technically, I said what I wanted to say. Technical correctness is the best kind of correctness. ;)
joosters 13y ago
1) The presence of non-savvy participants should encourage users, after all it means that there is money to be made! If the only users were insider traders, you'd be mad to join in. 2) Betfair had US election markets with hundreds of thousands of dollars at stake, and this is a site that blocks US users. So the interest and the money is there. (The legal/political problems in many countries are still a big hurdle though) Admittedly, the volumes are still peanuts compared to most sports markets... 3) Not really true. You win a bet if you get the result right, e.g. You predict the result of an event. You don't win by guessing the beliefs of others. Sure, you can trade in and out of a market as opinion changes, but you are still betting on a result and not an opinion.
- pdonis 13y ago
  You win a bet if you get the result right, e.g. You predict the result of an event. This isn't really true, at least not for most real prediction markets, because bets can be traded. The article gives an example: the author bought bets on McCain for the 2008 election early on when they were cheap, then sold them shortly before the Republican convention when they were fetching much higher prices. In other words, he wasn't really betting on McCain winning; he was betting on enough people believing McCain had good odds of winning that he could sell his McCain bets at a profit--i.e., he was indeed winning by guessing the beliefs of others.
  - joosters 13y ago
    Well, first of all, he didn't have to trade! Bets are be settled normally on the event happening or not, regardless of trading or of the motivation of the bettor. Secondly, just because he traded, doesn't mean he was solely betting on the beliefs of others. Odds can change over time because of betting activity caused by events, news and information. e.g. news stories, statements, etc. If those changes mean that the OP could trade out, good for him. Another example: Let's say NASA spots a huge asteriod in space, zooming towards earth. To pass the time, people are betting on whether or not it hits. (Let's not worry about how the bets get paid out!) Common consensus is that there is a 10% chance of a collision, but using your awesome physics knowledge, you reckon there's actually a 30% chance, give-or-take. So, you bet ON the asteroid hitting. A few days later, a news release from an esteemed astronomer reports that her calculations show that the asteroid is more likely to collide than previously thought. As a result, betting activity on the exchange adjusts and the consensus moves to 28%. Now, you might well be tempted to trade out of your bet at this point, and "lock in" a profit. After all, the odds are close to your own beliefs. Did you trade because of guessing the beliefs of others? No. You traded because the odds changed as a result of information changes, new info becoming public knowledge. You thought the original bet was value, and you traded out at zero cost to get certainty.
jonnathanson 13y ago
Exactly right. "The idea is that a true insider will place a large bet that provides valuable information to the market." Yes, and in practice, the true insider has every incentive to provide false information to the market, so as to manipulate people's expectations. The insider seeks alpha by trading on the resultant volatility in that prediction's pricing. Let's imagine I am the perfect insider. I have a crystal ball that somehow gives me 100% flawless predictive ability into the outcome of a particular bet (say, the next Republican primary). I could make a fair amount of money by betting on the winner, or I could make a lot more money by manipulating the information in the marketplace, creating volatility in the prices of the prediction bets, capitalizing on each fluctuation, while still holding some inventory in the correct outcome. If I knew the winner was going to be Joe Blow, I could bottom out Joe Blow's price by seeding false information, buy him low, then do the same for other candidates. Of course, the real world doesn't have perfectly predictive crystal balls. But because prediction markets are too small to cause real-world changes (i.e., there's no observer effect), manipulating information would not have a demonstrable effect on outcomes (as it would in a larger, more efficient marketplace). Ergo, as the insider with better info than most, my incentive is to mislead. I do not need a crystal ball to make a killing; I just need slightly better information than the rest of the market. The smaller the market, the more likely it is that my inside information is better than the market's. In a much bigger market, I couldn't get away with this strategy. At least not very easily or reliably. My seeding misinformation about Joe Blow would actually hurt Joe Blow's fundraising ability, thereby creating a self-fulfilling prophecy, thereby causing the market price to more accurately reflect reality. If I massively short Joe Blow, Joe Blow's chances actually drop. I'd get less alpha. But as you've said, the markets are way too closed and small to exhibit such an effect -- so I can rig the game accordingly.
- aamar 13y ago
  I could make a lot more money by manipulating the information in the marketplace, creating volatility in the prices of the prediction bets, capitalizing on each fluctuation, while still holding some inventory in the correct outcome. And one extreme version of this is mounting a credible campaign then "throwing" the race or withdrawing abruptly. This is attractive whenever the possible winnings in the prediction market are large and the market is insufficiently regulated. In ordinary financial markets, there can be special scrutiny paid to shorts, but the zero-sum game structure of a prediction market loses the distinction.

by hooande 13y ago

l1ghtm4n 13y ago

All very good points. I had worked some years ago on a prediction market site which attempted to merge 3 mechanisms for gaining collective intelligence: Polling, paramutual betting, and full buy/sell market. It was motived by the fact that full blown market simulations are a steep learning curve for the non-investor, but that person has a valuable opinion nonetheless. Never did much with it.

_delirium 13y ago

One added wrinkle is that some people may have a positive incentive to make inaccurate bets, if they have something riding on the perception of the outcome, that's sufficiently important to them to be worth spending the money pumping up the perception. Whether that's feasible depends on the size of the market, but if InTrade drives even some of the news cycle, and if $100k can move the InTrade needle on a relevant issue, then blowing $100k on it is essentially advertising spend, an attempt at image-boosting.

LanceH 13y ago
The issues do muddy the waters for using them as prediction markets. It is awesome, however for the savvy investor. My experience has been they are far, far more accurate than the media. It is the nature of the accuracy that is interesting, however. They come to decisions well in advance of the media -- weeks or even months early. A good example would be this last national election cycle, the prediction markets had Rick Perry and Michelle Bachman virtually closed out while their media coverage was still treating them as viable candidates. They aren't always right in the long run, but they converge on the right answers much sooner than anything else I've seen, Nate Silver's efforts included. The biggest problem is that in the US they are either illegal (deemed to be gambling) or just too small (IEM).
gwern 13y ago
> but if InTrade drives even some of the news cycle, and if $100k can move the InTrade needle on a relevant issue, then blowing $100k on it is essentially advertising spend, an attempt at image-boosting. True. Little enough good it did the Romney whale on election day, though: he handed $4m as a gift to all the other Intrade users, and it didn't move the needle anywhere.

javert 13y ago

Your initial thesis is not supported by your observations, which anyway are problematic. (1) This is not a "fundamental problem." Not every participant in the NYSE is a savvy investor, either. (2) This was also true of the automobile market. It didn't stop Henry Ford. This is a serious incidental problem, but not a fundamental one. (3) The best way to make money in a prediction market is to be able to predict the outcome of the predictions. You can also try to do what you're suggesting, and may have some success. Anyway, the evidence is that prediction markets work, both for hedging and for knowledge prediction.

pdonis 13y ago
The best way to make money in a prediction market is to be able to predict the outcome of the predictions. I don't think this says quite what you meant. :-) As it stands, it can be read as saying that you can make money by predicting what other people believe, which is in agreement with the parent's #3. (And which is also true--as I noted just upthread, the author of the article in the OP did exactly that by buying and then selling McCain bets for the 2008 election.)
- javert 13y ago
  This is a pointless nit pick, but two can play at that game. The outcome of the predictions is that all the correct predictions resolve to 1 (or 100% or what have you) and all the incorrect predictions resolve to 0. Technically, I said what I wanted to say. Technical correctness is the best kind of correctness. ;)

joosters 13y ago

1) The presence of non-savvy participants should encourage users, after all it means that there is money to be made! If the only users were insider traders, you'd be mad to join in. 2) Betfair had US election markets with hundreds of thousands of dollars at stake, and this is a site that blocks US users. So the interest and the money is there. (The legal/political problems in many countries are still a big hurdle though) Admittedly, the volumes are still peanuts compared to most sports markets... 3) Not really true. You win a bet if you get the result right, e.g. You predict the result of an event. You don't win by guessing the beliefs of others. Sure, you can trade in and out of a market as opinion changes, but you are still betting on a result and not an opinion.

pdonis 13y ago
You win a bet if you get the result right, e.g. You predict the result of an event. This isn't really true, at least not for most real prediction markets, because bets can be traded. The article gives an example: the author bought bets on McCain for the 2008 election early on when they were cheap, then sold them shortly before the Republican convention when they were fetching much higher prices. In other words, he wasn't really betting on McCain winning; he was betting on enough people believing McCain had good odds of winning that he could sell his McCain bets at a profit--i.e., he was indeed winning by guessing the beliefs of others.
- joosters 13y ago
  Well, first of all, he didn't have to trade! Bets are be settled normally on the event happening or not, regardless of trading or of the motivation of the bettor. Secondly, just because he traded, doesn't mean he was solely betting on the beliefs of others. Odds can change over time because of betting activity caused by events, news and information. e.g. news stories, statements, etc. If those changes mean that the OP could trade out, good for him. Another example: Let's say NASA spots a huge asteriod in space, zooming towards earth. To pass the time, people are betting on whether or not it hits. (Let's not worry about how the bets get paid out!) Common consensus is that there is a 10% chance of a collision, but using your awesome physics knowledge, you reckon there's actually a 30% chance, give-or-take. So, you bet ON the asteroid hitting. A few days later, a news release from an esteemed astronomer reports that her calculations show that the asteroid is more likely to collide than previously thought. As a result, betting activity on the exchange adjusts and the consensus moves to 28%. Now, you might well be tempted to trade out of your bet at this point, and "lock in" a profit. After all, the odds are close to your own beliefs. Did you trade because of guessing the beliefs of others? No. You traded because the odds changed as a result of information changes, new info becoming public knowledge. You thought the original bet was value, and you traded out at zero cost to get certainty.

jonnathanson 13y ago

Exactly right. "The idea is that a true insider will place a large bet that provides valuable information to the market." Yes, and in practice, the true insider has every incentive to provide false information to the market, so as to manipulate people's expectations. The insider seeks alpha by trading on the resultant volatility in that prediction's pricing. Let's imagine I am the perfect insider. I have a crystal ball that somehow gives me 100% flawless predictive ability into the outcome of a particular bet (say, the next Republican primary). I could make a fair amount of money by betting on the winner, or I could make a lot more money by manipulating the information in the marketplace, creating volatility in the prices of the prediction bets, capitalizing on each fluctuation, while still holding some inventory in the correct outcome. If I knew the winner was going to be Joe Blow, I could bottom out Joe Blow's price by seeding false information, buy him low, then do the same for other candidates. Of course, the real world doesn't have perfectly predictive crystal balls. But because prediction markets are too small to cause real-world changes (i.e., there's no observer effect), manipulating information would not have a demonstrable effect on outcomes (as it would in a larger, more efficient marketplace). Ergo, as the insider with better info than most, my incentive is to mislead. I do not need a crystal ball to make a killing; I just need slightly better information than the rest of the market. The smaller the market, the more likely it is that my inside information is better than the market's. In a much bigger market, I couldn't get away with this strategy. At least not very easily or reliably. My seeding misinformation about Joe Blow would actually hurt Joe Blow's fundraising ability, thereby creating a self-fulfilling prophecy, thereby causing the market price to more accurately reflect reality. If I massively short Joe Blow, Joe Blow's chances actually drop. I'd get less alpha. But as you've said, the markets are way too closed and small to exhibit such an effect -- so I can rig the game accordingly.

aamar 13y ago
I could make a lot more money by manipulating the information in the marketplace, creating volatility in the prices of the prediction bets, capitalizing on each fluctuation, while still holding some inventory in the correct outcome. And one extreme version of this is mounting a credible campaign then "throwing" the race or withdrawing abruptly. This is attractive whenever the possible winnings in the prediction market are large and the market is insufficiently regulated. In ordinary financial markets, there can be special scrutiny paid to shorts, but the zero-sum game structure of a prediction market loses the distinction.