Prediction Market Accuracy in the Long Run

Summary

Prediction markets are designed and conducted for the primary purpose of aggregating information so that market prices forecast future events. These markets differ from typical, naturally occurring markets in their primary role as a forecasting tool instead of a resource allocation mechanism. In this paper the authors suggest that the prediction markets outperform polls for longer horizons by documenting the evidence from 1988 to 2004 elections. They compare unadjusted market predictions to 964 unadjusted polls over the five Presidential elections since 1988. What they found is intriguing: The market is closer to the eventual outcome 74% of the time. Further, the market significantly outperforms the polls in every election when forecasting more than 100 days in advance.  In their study they utilized the Iowa Electronic Markets (IEM) prices and raw poll dataset. We can compile the merits of predictions markets compared to polls based on the study findings:

•      Polls can`t have the true random sample; whereas the prediction markets customers can be very heterogeneous.
•       Production markets can forecast complex phenomena due to several reasons.

o   The market design forces traders to focus on the specific event of interest more than simple consideration of a fictitious election “if it were to be held today” (as polls ask respondents to consider)

o   Traders must act rationale since they put money on stake.

o   Markets aggregates dynamic information from a wide variety of sources, i.e. traders.

o   The markets provide an incentive to generate, gather and process information across information sources and in a variety of ways. (If you do good, you prosper.)

•       For the five elections, the average absolute error in the market’s prediction of the major-party presidential vote share across the 5 days prior to the election was 1.20 percentage points, while opinion polls conducted during that same time had an average error of 1.62 percentage points.
•       Unlike polls` random selection, the participants of prediction markets are self-selected.
•       Unlike polls or expert panels in which participants are asked for their independent opinions, each trader in the market sees the net effect of the beliefs of all other traders, and the time series of changes in those beliefs and can alter his own perceptions accordingly.
•       Unlike polls that ask each respondent how he or she would vote if the election were held today, the market asks traders to forecast how everyone will vote in the actual upcoming election. (We can suggest that the sentiments play role on polls; whereas the factuality in PMs)
•       ``Convention bounce`` effects don`t appear in prediction markets.
•       It gives continuous updates.
•       Because they react dynamically to information, they can also be used as evaluation tools to assess the impact of decisions such as policy positions, candidate viability, campaign strategies, etc.

Critique

The study lays out the facts effectively. The authors compile the prediction markets` advantages and superiorities over the polls. However, the study does't mention about the weaknesses of the technique which can be the sign of confirmation bias. Moreover, polls attract many attentions currently. If the prediction markets have lots of merits over polls, I would expect the study to identify the reason why still polls make people interested in them. Nevertheless, the study explains very well why the prediction markets outperform polls through five consecutive years.

Source:

Berg, J. E., Nelson, F. D., & Rietz, T. A. (2008). Prediction market accuracy in the long run. International Journal of Forecasting, 24(2), 285-300.