## Tuesday, December 16, 2008

### Prediction Markets Review

Yesterday the Electoral College delegates voted, 365 for Barack Obama and 173 for John McCain. How did the markets do?

To compare, here is my map the night before the election and the final results. The leaning category had Obama at 364. The markets leaned the wrong way for Missouri and Indiana, their 11 electoral votes canceling each other out. The extra vote for Obama came from a quirk in Nebraska that the Intrade markets didn't cover: Nebraska splits their votes based on congressional delegations, one of which went to Obama.

Indiana and Missouri were the most likely Republican and Democratic states to switch sides according to the markets, which mean the markets did very well this year again. Had every state leaned the right way (again), one would wonder if the probabilities in each state had any meaning beyond being above or below 50%.

Many argue the markets just followed the predictions based on polls like Nate Silver's fivethirtyeight.com. True to a point, Silver did amazingly well and the markets smartly trusted him. But the markets also did very well in 2004 without Silver. One can aggregate polls and other information using hours upon hours of analysis or one can just trust the markets to get essentially equally good results with little effort.

In some other prediction market news: A couple of years ago, Tradesports spun off their non-sports markets into a new site Intrade. Last month Tradesports shut down. Intrade still lives and hopefully it will continue to provide an exciting collection of political and other prediction markets.

Cantor Fitzgerald, owners of the Hollywood Stock Exchange, have filed with the CFTC to create real money markets based on box office receipts. Each share will pay off one-millionth of the first four weeks of the film's gross. They don't call it a prediction market since it doesn't have a binary outcome but I do because it is based on a specific time-limited event and the price should accurate reflect the expected gross of the movie.

Not market related but the big news in Illinois is of course the embarrassment of our governor right after the Obama high we've been on. At least Blagojevich will, hopefully, fade from view soon while Obama should leave a strong legacy as president that we in Illinois will remember for a long time.

1. "...or one can just trust the markets to get essentially equally good results with little effort."

Your point about the predictive power of these boutique markets is somewhat dulled by the fact that the big markets haven't been doing very well at predicting much of anything recently.

2. to provide an exciting collection of political and other prediction markets.

These markets are as much a "prediction" tool as a wind vane or outdoor thermometer are. They moved up and down according to the daily trends, with very little insight of the longer place phenomena underlying them.

When the weather was hot (Palin's nomination announcement) the market swinged widely towards McCain, while ignoring the cold front on the way here (the economic recession + Palin inexperience).

The value of weather forecast is in telling us things we didn't know. We don't need to trade securities to believe that if McCain is closing on the polls then his chances of wining are higher (duh!), which is what the markets did. We need sophisticated prediction mechanisms to tell us how the worsening economic conditions, the war in Iraq and Palin ineptitude (which in pre-Couric days wasn't as well established) will impact this election, today poll's be damned.

Looking at the actions by the republican teams, who were trying to read past the daily trend all the way to November 4th, it is clear that they thought all along they were losing by a fair margin. Because of this is they choose moderate, maverick McCain, went for the Palin hail mary fumble^H^H^H^H^H pass and the put-the-campaign-on-hold move.

A full two weeks before the election the McCain team concluded the election was unwinnable, while the electoral college market was still giving 25-35% odds to McCain.

3. Kurt's comment brings up a big point: The stock market has lots more inside information that the average shareholder just can't know or have the time to assess. There is also an inherent bias upwards in the information in the system because that is what brings in the commissions and the bonuses - zero-sum markets don't have this feature.

In an election prediction market, lots more things are out in the open. What constitutes insider trading here? (Does learning about damaging news early count?)

The Hollywood market does seem somewhat different in that there are small test audiences and insider information could be a big deal.

4. I think a more interesting question is how long before the election were the prediction markets "essentially" accurate? Predicting the various outcomes 24 hours ahead of time could likely be done by polls.

Were the prediction markets within 5% of the actual outcome continuously for the 30 days preceding the election, though?

Eric

5. Recently I am not involved in political discussions as much as I was used to, but there is a comparison here which I have to make: Both Obama and Palin rose to power in states owned by corrupt parts of their respective parties. Obama grew through the system and remained clean, not a small feat. Palin fought the system all the way, won in part, and apparently remained less clean than Obama. I will leave to others the question of what is preferable.

6. How did Palin only win "in part, and apparently remained less clean" when she was officially cleared of everything while the media have been hounding to find a speck in her records? Why not support your favorite politician without trashing his opponent?

7. Some observations on the predictions:

- In the case of solid red/blue states there aren't enough incentives to push the price all the way to their true probability. E.g. does any one really believe that on the eve of the election McCain had a 3% chance of winning in NY as indicated by your map? Trading costs (or lack of willing traders on the other side) kept the price from being pushed to its true value of 99%+.

- The error above, while small, when present in all 50 states on a close election leads to an underestimate of 10% and beyond on the probabilities of the winner. You can run the numbers or simply compare the 90% chance for Obama of ElectoralMarkets.com with the 98%+ of fivethirtyeight.com, where this bias was not present.

- Surprisingly trading reflected heavy emphasis on "next quarter" performance (i.e. short term success/failure as opposed to long term business planning) just as in the stock market.

To give an example, last night the price of Indiana contracts fluctuated widely with each swing in the polls, yet a simple extrapolation of the returns per county indicated that the outcome would be extremely close and as such the fair price should have been 50% pretty much all the way until near the very end of the ballot counting process.

A second example of short term thinking was when McCain contracts went sharply up from the period right after the Republican convention until just before the financial collapse. How so?

Let's use a mathematical example to illustrate the principle: consider two rather evenly matched poker players. The only difference is that one starts with $1000 while the other starts with$10. Every poker player knows that the odds are dramatically in favor of the guy with $1000, and would give very little weight to the outcome of any individual hand in handicapping the odds during the game. Essentially the odds should only change on the basis an inordinately long sequence of winning hands. Now back to the election, where Obama had the equivalent of a$1000 advantage, with Bush being the most unpopular president in history, two military quagmires in Asia, an economy which was already weakening, expensive gas prices, Obama being an extraordinarily gifted orator, the internal split within the republican party among the different camps (neocons, religious rights, mavericks, fiscal conservatives), etc.

Yet, McCain contracts swung back dramatically right after the republican convention even though the Palin nomination was the equivalent of having won one or two hands in what still remained a very uneven contest.

Alex