Understanding Prediction Markets

For some time now, there has been a debate about how useful Prediction Markets can be. Some will say that the odds reflected on prediction markets have to be incorrect, otherwise how would anyone, myself included make a profit? They will use examples of where the price on Intrade differed from what actually happened and use it as proof that prediction markets are inaccurate. Likewise, proponents of prediction markets will use examples of “successful” predictions made by the market as evidence that they are more accurate then other forecasting tools such as polls and expert opinions from the media. Both these arguments are incorrect.

Prediction Markets are useful because they usually reflect the current odds of an event happening, at that current time, all other things being equal. For example, Tiger Woods currently has an 80% chance of returning to the PGA tour by the end of April. Would it be an incorrect prediction if Tiger Woods does not actually come back? No. Like all things about the future, there is some uncertainty. Even the high price that Tiger Woods is currently trading at, tells you that all is not certain. A lightning bolt could strike and kill him on the golf course, his wife could change her mind and forbid him to play at last minute. There is still a 1 in 5 chance of him not coming back. As anyone who has played poker can tell you, a 20% chance of being beaten on the river will happen from time to time.

The usefulness of prediction markets comes from the aggregation of information into a price/probability that the brain can easily understand and interpret. This is why Intrade and prediction markets can be useful. Sometimes the odds will not be accurate, but the point is there is an incentive to change the price if it does not reflect the current odds of an event in the future. Prices on Intrade are valuable pieces of information by themselves, but they must all be taken with a grain of salt. The future is uncertain. No one can tell you with any certainty what is or isn’t going to happen. That is why those who seek out information, think rationally, and trade logically will profit.