Prediction Markets and the Palin Pick
posted by Nate Oman
Palin is McCain’s VP pick, but the inTrade markets seem to have been caught flat footed. Here is the graph of her contract’s performance over the life of the speculation:
Notice that she never seems to have traded at above 20 and immediately before the announcement she was trading in the single digits. I’ve had an on-going discussion with some friends about the value of inTrade numbers, and the anti-inTrade voices have been crowing this afternoon that Palin’s pick shows the bankruptcy of prediction markets. “I argue against putting too much weight on prediction markets,” one friend said, “which I think are interesting but not of tremendous political value or somehow more predictive that good polling data.”
So does this show that the inTrade is bunk and we ought to rely on expertise?
It’s hard to say. I can think of a couple of different stories that one might tell here. First, you could — as I think my friend does — assume that inTrade numbers are driven by essentially uninformed speculators responding to momentary fluctuations in the flow of information from the 24-hour news cycle. Better to ignore the noise and go with thoughtful experts who base their analysis on reasoned elaboration. The failure of inTrade to pick Palin is just a case in point.
There, is however, another story that we could tell. “Prediction market” is actually a misnomer. inTrade is not a predictor but rather an aggregator of information. If we assume that self-interested investors are not throwing their money away, then the markets should respond to the available information and provide us with a rough sense of the probability of particular outcomes given that information. Note, if we suppose that these markets will accurately gauge probabilities it doesn’t follow that their predictions always come true. After all, sometimes improbable events happen. Also, the markets are going to at best reflect available information and sometimes key bits of information just aren’t available.
Accordingly, it seems to me that we have three possible ways of evaluating the inTrade failure to pick Palin. First, inTrade may simply be bunk. Second, Palin’s choice may simply have been a very improbable event that happened to come to pass. Third, it may be that in the period running up to the choice of Palin there just wasn’t all that much relevant information available about the relative probabilities of who was being chosen.
If you think that the first answer is correct, then you ought get an inTrade account. There is good money to be made trading against the ignorant, CNN-driven masses. If you think that the second answer is correct, you should take comfort from the fact that fairy tales do indeed come true sometimes. If you think that the third answer is correct, then you ought to realize that the torrent of expert puditry is an illustration of the iron law of gaseous knowledge, namely that any amount of knowledge or information — no matter how small — can be puffed and expanded to fill any space of ignorance — no matter how large.