Erik Larson

May 16, 2010

Prediction Markets

[This is a draft from a few months ago, but I’m posting it in hopes that it’ll prompt me to finish it. Maybe it will stimulate someone to want to hear more (or, do YOU want to finish it? If so, get a copy of “Infotopia” by Harvard Law prof Cass Sunstein, if you haven’t already. I started writing this up after reading this book.).]

Prediction Markets are a fancy name for the age-old idea of betting on future events or outcomes, or “putting your money where your mouth is”, in other words. In a prediction market, participants can place bets on whether, say, health care will pass, or whether Obama will get re-elected (if he runs), or (more controversially) when the next major terrorist incident will occur on American soil, and so on. Researchers have found in recent years that Prediction Markets are remarkably accurate. In many cases, they outperform the predictions of subject matter experts, and other types of group-aggregation predictors like polls, or deliberative groups. For example, the Iowa Electronic Markets, run by the University of Iowa since 1998, is a popular prediction market that has psroven effective in guessing election outcomes. The IEM results had Bush with 50.45% of the vote, and Kerry with 49.55%, compared to the actual 51.56% for Bush and 48.44% for Kerry. The result, based simply on people placing bets on the final outcome of the election, outperformed professional polling results.

The question is, why? Why is betting such a powerful tool for predicting the future? Participants in Prediction Markets—bettors—don’t have to have a Ph.D. in the electoral process; they don’t have to have access to special information; they don’t really need any credentials at all, short of agreeing to partipate by putting up some initial money and hoping to get more by guessing correctly. And yet, collectively, the Prediction Markets often outperform the experts.

The story of why Prediction Markets (hereafter PMs) work so well is best told by telling another story, one of how deliberative groups often don’t work well. In a deliberative group, members, well, deliberate: they discuss and analyze some topic or set of possible outcomes and decide on a course of action, or a most likely outcome, or a best policy, depending on what is getting deliberated. Deliberative groups often do produce good outcomes (perhaps the most famous example of the success of deliberation is the ratification of the American Constitution, where sustained discussion about the details of the Constitution resulted in the document we have today).