I’ve been taking part in the Good Judgment Project, which is attempting to predict global events. I’ve discussed some of the quirks in the design of the prediction markets. Here’s a few more.
Most of the questions involve binary events, but every once in a while there are multiple options in winner-take-all markets. A recent example is this question (click to expand):
Note that there are five possible outcomes. When the question was first posted (February 7, 2012), each of the outcomes was given a 20% likelihood of coming true. As a result, early purchasers (like me) could purchase an outcome that would pay off relatively handsomely. I was able to pick a very likely winner, simply by acting swiftly. One very quick Google search yielded enough information to select (b) Henrique Capriles Radonski as the overwhelming favourite.
Of course, the same thing happens with binary markets, where the initial likelihoods are set at 50%, meaning you can double your money by being the first to pick the right outcome. The problem is exacerbated when there are multiple contracts in the market. In this case, I will quintuple my investment, if correct.
The issue is that some participants can achieve significant “profits” without actually having much real knowledge or superior predictive abilities. One of the purposes of a prediction market is to identify the best predictors – they end up with the most money, allowing them to have a greater say in future predictions. In cases such as these, there are windfall gains to be had by the earliest traders, because the initial odds are not set properly.
The odds are set, assuming no information is available to make a decision. That is, it’s kind of like a five-sided die roll or a coin flip for binary events. In the above case, there is information available, which should have been taken into account in setting the initial odds. We can assume there was quite a bit of “good” information about the outcome, because within one day, the likelihood of the frontrunner jumped from 20% to 92.8%!
Another quirky design issue involves limiting trades to $1,000 per market. This restricts someone with superior knowledge from having the appropriate amount of influence in a market. To my way of thinking, this runs counter to prediction market theory. Essentially, these market quirks preclude a successful trader from being able to justifiably influence any market, but it does allow him or her to invest in more markets than unsuccessful traders. Of course, the early winners will be able to maximize the number of markets in which they can make the maximum bets.
Short-term vs. Long-term
Another interesting observation is that new questions are added every few weeks. While I have done reasonably well, I still find that I am almost fully invested, without being able to take positions in all of the markets I would like to. When new questions arise, I have to decide whether I wish to get out of some markets in order to invest in new ones. This involves deciding whether it is better to get out of a long-term question (say 3 – 12 months hence), which may pay off handsomely, to be able to invest in one or more shorter term markets, which may collectively pay off even better.
In other words, you have to keep your money “working”. Long term investments are riskier (more unpredictable intervening events may occur) and tie up your money. So, even though you may have superior information about a market outcome, it may not be financially appropriate for you to act on it and place a bet. This provides incentives for traders to invest where they have the best information relative to other traders, even though they may have better information than other traders in many (or all) markets.
This is probably a good thing, but, by design, the overall exchange is leaving “good” information on the table!