[BretLudwig]

Smart Money

Political futures markets are better predictors than polls.

by Michael Brendan Dougherty

"In November 2004, a man with half a million dollars was looking to
double his money. He could have gone to a high-stakes table in Vegas. He
could have put his money in a hedge fund and waited. Instead, he signed on
to a Dublin-based website, Intrade, the night before the presidential
election and put everything on George W. Bush, then running even with John
Kerry. The next morning, he was a millionaire.

Carl Wolfenden, the acting exchange manager of Intrade, explains the logic
of prediction markets: €œOur members sign up and trade with the intention
of making money. One of the byproducts of that, the pricing information
that they generate, translates into probability. The market pricing is
measuring the probability of uncertain future events.€� The results are
eerily accurate.

Tens of thousands of people bet money on who would win each state in the
2004 general election, and Intrades political futures market predicted
the winner in all 50. Two years later, the Intrade favorite won every
single Senate race. Investors, or, if you prefer, gamblers, were
generating political predictions far more accurate than professional
pollsters. They were also winning and losing piles of money.

But the political prediction markets didnt begin with high-rolling
political junkies. They started with a few dozen college students. In
1988, the University of Iowa business school opened the Iowa Electronic
Markets as an experiment. They allowed anyone to buy contracts based on
how they thought a given candidate would do in an upcoming election. The
market developed a price per share. If the market moved Candidate As
price up to 50 cents a share, it was saying that Candidate A had a 50
percent chance of winning.

€œWe collected almost 1,000 polls that came out during the election
cycles, and compared the poll prediction to the IEM prediction,€� says
Professor Joyce Berg, €œand in 75 percent of cases the IEM was closer to
the actual outcome than the polls were.€� One study showed that IEMs
prices on the eve of an election were off by an average of just 1.37
percent.

Berg says that the people trading are nothing like a random sample of
voters. €œIn 1988, everyone was from Iowa, and we only had 155 people in
the voteshare market. Even now, when we have thousands of people in each
market, we are not distributed among states by population. Our traders are
overwhelmingly male. They have more education than the average voter. They
have a higher income than the average voter. But the market mechanism is
one where we dont need a random sample of voters, we need people with
information.€� In other words, a large representative sample of the
electorate cannot accurately predict its own behavior when asked a simple
question. But a group of students betting their spring break money can.

The IEM limits its traders to accounts between $5 and $500 in order to
avoid a crackdown by the government. Those who want to make larger wagers
have to go overseas and deal with Intrade. The Internet Gambling
Enforcement Act of 2006 prohibits American banks from making credit-card
payments to offshore gambling sites. The only Americans betting on Intrade
have offshore accounts and use foreign addresses. If Wolfenden set foot on
U.S. soil, he would probably face arrest and prison. But the exchange he
runs is the most hailed prediction market worldwide.

This year, over 50,000 contracts were bought on the New Hampshire primary,
and so far 2 million contracts have been purchased on the Democratic
nomination. Clintons futures were more highly valued than Obamas
even after a string of Super Tuesday defeats. But once news broke that
Clinton was lending her own campaign money, Obamas price surged ahead
in both the IEM and Intrade.

There was almost as much interest in Republican outcomes. Those poor souls
who were bullish on Fred Thompson either sold short or stayed in their bad
position, losing everything. But one couple gained a small fortune. Last
summer there seemed to be no chance that John McCain would be the nominee.
His amnesty bid backfired, his poll numbers in Iowa plummeted, and he
couldnt raise any money. His price on Intrade dipped below 5 cents a
share. But one trading duo, Bethen and Jonathan, saw an opportunity. If
McCain won the nomination, each share they bought for a little under 5
cents would pay a dollar. Already theyve seen their investment increase
in value by a factor of 19. Barring any dramatic developments between now
and the convention, the pair will be tens of thousands of dollars richer.

The small trend of prediction markets officially became a phenomenon when
James Surowiecki included them in pop-economics bestseller. A financial
journalist for The New Yorker, Surowiecki landed on the lists with The
Wisdom of Crowds in 2004. He touted sociological studies showing that a
group of people guessing the number of jellybeans in a jar was almost
always more accurate than any one single person. In case after case,
crowds of people in the free market could aggregate and organize
information like nothing else. Surowiecki promoted the Hollywood Stock
Exchange (which only uses play-money) as the most accurate predictor of
box-office receipts. He named the IEM and Intrade as the best sources for
political predictions, saying, €œa decision markets fundamental
characteristics€”diversity, independence, and decentralization€”are
guaranteed to make for good group decisions.€� Prediction markets
werent just a fun trend in gambling, they represented a big idea: mobs
can be more clever than individuals.

But there are some anomalies in prediction markets. Al Gores prices in
the 2008 Democratic nomination markets were higher than announced
candidates like Bill Richardson and Chris Dodd. As late as last fall, he
had a one in five chance of taking the nomination, though he wasnt
running. Wolfenden explains, €œThere seems to be a group of traders who
are Al Gore fans. Some of them are still holding out the possibility that
he may be the Democratic nominee.€� Gores inflated stock reflects a
similar phenomenon in sports. A Giants line can almost never be trusted
because there are so many New York football fans who feel they cant bet
against the home team. Intrades clients, made up of foreigners and rich,
college-educated American males who have offshore accounts, have serious
man crushes on Gore.

Despite small blips like this, high-ranking officials may want to
periodically check in on their job security. As the 2006 Congressional
election approached, rumors that Secretary of Defense Donald Rumsfeld was
on his way out had died down, so his resignation the day after the
election shocked the major news media. If network executives had checked
the predictions markets, they would have seen traders bid Rumsfelds
departure up by several factors in the 24 hours before he resigned.

Intrade takes investments on more than political outcomes. High-volume
traders make several thousand dollars a day betting on whether American
financial markets will finish up or down. The market also allows people to
bet on whether Scooter Libby will receive a pardon by the end of Bushs
term (currently trading high at 65 cents a share) or whether the first
Category 3 storm of the next hurricane season will make landfall in
Florida, Texas, or Alabama. You can even bet on bird-flu. Would Intrade
take bets on when the pope will die? Wolfenden says no. €œFor a
proposition to be traded it has to fall within the bounds of good taste.
We try not to get into death contracts or that sort of thing.€� The
markets principals dont want to encourage anything untoward, but
they do take suggestions. €œThe craziest one weve been asked for was:
€˜Jesus to return in next ten years, or Rapture, or apocalypse,€�
Wolfenden reports. How Intrade would pay out if the apocalypse occurred
was not specified.

Prediction markets also furnish us with a prospectus for peace. The
numbers are grim. There is only about a 5 percent chance of Hamas
recognizing the right of Israel to exist by Sept. 30. And according to
market wisdom, America is nearly twice as likely to €œlaunch overt
military action against North Korea€� by New Years. A second Korean
War would probably rate higher if the Bush administration werent
rattling its sabers at Tehran. Traders are giving war with Iran a one in
five chance by the close of the third fiscal quarter. And investors are
not bullish on the chances of catching Osama bin Laden. Wagers on his
capture by 2009 are trading at just over a dime.

Those who have qualms about betting on war and peace still have the more
conventional 2008 horserace. Jim Webb is trading in the vice presidential
markets at almost the same price as Hillary Clinton. But nearly one third
of investors have put their money on €œthe field,€� believing Barack
Obama will choose a relatively unknown candidate. On the Republican side,
Minnesota Gov. Tim Pawlenty is the one in five favorite, and Mitt
Romneys recent grinning and groveling are moving his veep shares up
quickly.

But if the numbers hold, its doubtful that either will see high office
soon. The IEM has the Democratic share of the presidential vote around 50
percent, and the Republican share at 47 percent. The smart money says
President Obama."


http://www.amconmag.com/2008/2008_06_02/article4.html

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