Prediction Markets: A Better Tool for Forecasting & Situational Awareness

Wed, 07 Dec, 2016

By Perry Despeignes

  • Will Iran test detonate a nuclear bomb within the next two years?
  • Will Israel attack Iran?
  • Will at least one state attempt to secede from the "United" States?
  • Will ISIS launch a mass attack on a top-40 Western city causing more than 100 casualties by the end of next year?
  • Will Saudi Arabia’s monarchy be dethroned in a coup d’etat?
  • Will the euro’s purchasing power collapse at least 30% within the next year?
  • Will there be a shooting incident between China and another Asian country within the next few years?

One of the big wildcards: tensions in the South China Sea

  • Will there be a shooting incident between Russian and NATO air, land or naval forces within the next two years?
  •  Will another big Hollywood studio experience a major internet-related security breach?
  •  Will Slack.com be breached resulting in the theft of high-value business intelligence involving thousands of users from dozens of American corporations and start-ups?
  •  Will Chile get hit by a mega earthquake resulting in at least $1 billion in property damage and the loss of 100,000 Chilean lives?
  •  Will a miracle cure for diabetes be discovered?
  •  Will a new global epidemic claim the lives of at least 1,000 on U.S. soil within the next two years?
  •  Will mind controlled cybernetic exoskeletons for the handicapped be available to a mass audience in two years?
  •  Will the Mars Curiosity Rover discover organic matter on Mars?
  •  Will Foxconn lay off more than 25% of its workforce?
  •  Will the S&P 500 soar 20% over the next 12 months (or collapse by the same amount)?

We live in age of uncertainty -- opportunity and risk. We have the habit of looking to surveys, polls, experts and news media for guidance. The problem is, they're contaminated by “noise” — by bias, ego, error, flawed methods, ideology, groupthink, habit, inertia, political correctness, taboo, vested interests, ulterior motives, fragmentation, deception, intimidation, cults of celebrity, cliques of punditry, flat-out ignorance, inaccuracy and random fluff.

Pundits are often wrong – sometimes catastrophically so. Many predicted "no Brexit" and "no President Trump" with millions of lives and hundreds of billions of dollars in asset values on the line.

Those are just the latest examples. Over the past two years, we’ve been beset with big surprises and even bigger questions about the future direction of the "United" States, the "United" Kingdom, the European "Union", Russia, China, Japan, South Africa, Cuba, Venezuela, Egypt, Iran, Israel, the rest of the Middle East, finance, commerce, artificial intelligence and the future role (if any) of human beings in their own economy. We could all use a more effective tool that provides greater clarity about the future.

What if we made better use of the “Wisdom of the Crowd" -- the idea that no one of us has a monopoly on all knowledge, insight and access to facts about everything, that we all have fragments of the puzzle, that two minds are better than one... and a thousand, million or a billion minds are that much better.

"Wisdom of the Crowds," James Surowiecki's pioneering book on the concept

What if we made better use of this the notion of “collective intelligence” -- the basic rationale for democracy, jury-based judicial systems and any collaborative group decision making -- the idea is that none of us has a monopoly on the truth about everything, so decision-making is best distributed away from a single person or small homogeneous group (be it a king, dictator, a single judge or select committee) and spread across a much larger, more diverse group of people to reduce exposure to individual character flaws, error,  ignorance and other defects.

What if we made better use of market incentives to bring disparate knowledge - these fragments of knowledge, insight and access to facts - together? What about the idea that getting people to "put their money where their mouths are" is more effective than just asking them to say what they think. People talk, but money talks more clearly, more honestly and reveals more. And markets are the most effective way of pooling knowledge as people reveal what they think and what they truly expect through the act of buying and selling.

Prediction markets, where people bet on future outcomes by buying or selling shares in different potential outcomes, surface that collective intelligence - using the profit-seeking/loss-avoidance motive as a draw. They're windows into the future in which people “say” what they think will happen by “putting their money where their mouths are" and therefore have a financial and reputational incentive to get it right.

All markets are forms of prediction markets — prices in markets for all goods, all services (including all labor) and all assets are driven by expectations about the future:

  • investors in equity markets buy and sell stock in companies - driving share prices up or down - based on whether any particular expected event (CEO departure, new product launch, buyout/merger, etc.) will drive any given company's sales, profits and general value up or down
  • speculators trade of coffee, oranges, pork bellies, copper, natural gas and other commodities buy and sell based on whether government policy, weather or any other expected development will lead supply to outpace or further outpace demand or vice versa. Just the hint of the risk of a possible war (rather than the actual reality of one) can buffet the price of a commodity (like oil) whose availability is seen as vulnerable to the risk of disruption.
  • land prices typically soar on expectations new highways, commercial centers, new infrastructure or other big investments will be built nearby
  • salaries (which are basically “prices” for labor) are based on the value added employers expect workers to bring in over the coming year.
  • one of the most effective predictors of Brexit wasn't the media or pundits, but betting prices. The most effective indicator of election prospects for Trump, a sharp critic of illegal immigration through the southern border, was the Mexican peso.

"Pure" prediction markets isolate and filter speculation to speculation about specific events. With binary prediction markets, making a share in a prediction worth, say $1 if it happens and zero if it doesn’t, the price of the prediction at any time becomes a rough measure of what "The Crowd” thinks of the probability of that specific event.

That information tends to be of remarkably high quality. They're not perfect, but it turns out that prediction markets are more accurate on average than the usual surveys, industry forecasts, experts and pundits. That’s clear from a massive and ever-growing library of case studies and academic research. Just do a Google Scholar search for "prediction markets."

Why do they work?

  • Since good trading performance is rewarded by financial gain and bad trading performance is “punished” by financial losses, prediction markets reward expertise and “punish” the not-so-knowledgeable who answer without having a clue. Over time, knowledgeable people who know earliest gain more of a voice than people who know less or later.
  • Prediction markets pool diverse perspectives, so that even as knowledge on the system piles up, many of the biases cancel each other out.
  • Their biggest rewards go to whomever gives “signals" earliest that stray furthest from the conventional wisdom. In other words, prediction markets give the biggest rewards to those who dissent the most and the earliest from erroneous groupthink. Imagine a better Early Warning System – for Everything – that tapped into the collective intelligence and awareness of Humanity.

Imagine that we're on the brink of a Seventh Information Revolution, an information revolution being a quantum leap in human being's ability to access knowledge, expand situational awareness, reduce the scale and scope of ignorance, confusion, deeption, risk and uncertainty.

Language was the first, then prices (which allowed for instant communication of information surpluses and scarcities, low and high value), then the printing press (which allowed wider dissemination of textual knowledge to the masses), then electricity (allowing two-way, interactive transmission of voice and text over long distances), then TV and radio (enabling one-way broadcast over entire nations), then the Internet (allowing easier multi-way, multi-person, nearly-instantenous, interactive, transmission/broadcast/feedback across a wider spectrum of multimedia planetwide).

Well, now we suffer from information overload - and a lot of it is bad information

Imagine that Open Prediction Market Platform heralds the Seventh Information Revolution, enabling quicker, cleaner, easy-to-monitor, easy-to-track broadcast of knowledge and a new (and in many ways more efficient) way of keeping up with the current state of the world, including "out of the box" thinking that dissents from the (often wrong) conventional wisdom - a system that instead of relying on words and elaborate opinions is, in the words of a McKinsey & Co study "an effective way to lower the threshold for sharing information and still catches the prevailing mood."

Imagine that unlike previous information revolutions that dramatically increase the quantity of information, the single biggest contribution of prediction markets is a revolutionary improvement in the quality, digestibility and access to information. Centralized prediction markets like the ones mentioned here are typically regulated, restricted, more limited in access and users. They might not have performed all that well this time because of these limitations.

Imagine the first truly global, truly open (to everyone with an Internet connection), truly borderless, truly friction-free market for predictions. A "market of markets" able to harness the collective intelligence/awareness of the world in a way no other prediction market platform has before. A system that tapped into the biggest and most varied population of traders any prediction market -- any financial market -- has ever seen making the predictive power of that system that much more robust.

Imagine a platform that allowed anyone from anywhere to create a prediction market about anything, trade in one or simply monitor one to get a clearer sense of where things really stand and where they're going on any topic or subtopic of widespread interest, allowing us to be more quickly alerted to what are now considered "black swan" risks.

Imagine a new easy-to-navigate, user-friendly early warning system, a new weather forecast dashboard, a new GPS, a new Bloomberg/Reuters like terminal displaying an open-ended array of market-driven, crowdsourced forecasts on any topic of widespread interest.

Imagine a platform that could bring some serious relief to This Age of Rampant Distraction, Confusion, Disinformation, Noise. Imagine the closest thing to a real crystal ball.

Well, you might not have to imagine for much longer. The Augur platform (http://augur.net) -- an open, global, decentralized prediction market platform currently in beta (http://app.augur.net), to be accessible to anyone with an Internet-connected web browser -- is likely to be deployed by early next year.


The Augur Platform (beta version): http://app.augur.net