Once More, With Feeling
Judging by the pre-vote polls and prediction markets, the Democratic primary in New Hampshire created one of the most surprising upsets in U.S. political history.
Many take this to show prediction markets have failed. Paul Krugman:
Prediction markets – which you see, again and again, touted as having some mystical power to aggregate information, know no more than the conventional wisdom. … There’s no hint that the market saw either Iowa or New Hampshire coming, or knew anything beyond the bloviations of the talking heads.
So, I’ve been watching the action in one of the political futures markets this evening, Intrade. And the action in this prediction market has reinforced my opinion that these are less futures markets than immediate-past markets. The price movement tends to respond to conventional wisdom and polling data; it doesn’t lead them.
Again we see the usual media formula: when prediction markets give a >50% chance to what happened, they are hailed as oracles, but when they give a <50% chance, they are unmasked as charlatans. But this is just the wrong way to evaluate such things. Justin Wolfers:
Prices suggest a probabilistic statement that the ultimate outcome was about a 7% chance. And as any horseplayer can tell you, sometimes the long shots do win.
We do not claim that prediction markets will always be more accurate that other methods. Often other institutions do pretty much the best they can. Rather, compared to other long-lived institutions which make frequently-updated probabilistic forecasts, we claim that well-traded prediction markets will in most situations rarely be much less accurate, and in some situations be much more accurate. Often other institutions are seriously broken, and do much worse than is possible.
"If Intrade overreacts on a regular basis, and not just on occasion, then this suggests there's an easy way to make some money, as well as starting to correct this at the same time."
This argument gets used a lot. However, the people who know better may not have enough money or want to risk enough money to actually correct the odds.
How much risk is it? Suppose that the market is agreed that a candidate has a 10% chance but I have looked at all the available information very carefully and I believe it's an 80% chance based on that information. How much money should I put on it? Say I invest $50,000 in this candidate and tomorrow an old girlfriend shows up who talks about his sexual fetishes? i couldn't have predicted that, and I'm probably out $50,000.
This might be a reliable way to make money if you can average it out over hundreds of thousands of bets, but I think the stock market is less risky. If the stock market overreacts on a regular basis, then I don't depend on an unknown event. I win when they overreact provided I could get in place to profit by it.
I don't believe arbitrage has anything to do with accuracy. In fact, the word 'accuracy' in the context of prices is about as useful as the word 'fairness' in the context of taxes (how's that for a troll ?).Arbitrage just implies a momentary difference in assessment.