Betting on ideas

The September edition of Spectrum¹ ran a piece² on how some companies and institutions are using a stock-market/betting/speculative-investment model to test out new ideas, products and to make forecasts. A basic outline of this model:

 

So how do prediction markets typically work? First of all, they use real money. That’s important for keeping bettors honest. The price you pay is set by the market’s opinion on the odds of that outcome. If, for example, you have to pay 33 cents for a bet that former U.S. Senator Fred Thompson of Tennessee will be the Republican candidate for president of the United States next year (the price in mid-July), and 40 cents to bet on Rudolph Giuliani, former mayor of New York, then the market says there is a 1 in 3 chance of Thompson getting the nomination, while Giuliani’s chances are 2 in 5.

 

 

I thought it was a very neat idea, and though it has been around for a long time (150 years according to the article), I had never heard of it before. It is really a brilliant and effective method of using distributed and imperfect, localized information of people in-the-know to predict larger trends and mine for deeper knowledge embedded in the system. To quote from the article:

 

As explained by financial journalist James Surowiecki, who wrote the 2004 book The Wisdom of Crowds, “under the right circumstances, groups are remarkably intelligent, and are often smarter than the smartest people in them.”

 

This system is a classic example of economic thought – with respect to the value of money, and how betting games are a great way to test a certain theory or claim:

Prediction markets work so well because they ferret out those confident enough to back up their beliefs with cash. Suppose a marketer wants to predict what his company’s sales figures will be in the next quarter. He can set up a prediction market that puts the question directly to his salespeople, ­marketers, accountants, and others. The market gives those people an incentive to express their knowledge. The hope of winning money smokes out people who think they know the right answer, so the group of bettors is self-selecting.

Of course, some people don’t know as much as they think they do, and some will make lousy bets. But as it turns out, that’s a feature, not a problem. As long as there are people with both money and expertise, they will trump the bad betting of the ill-informed and overconfident with additional wagers of their own.

 

It is a very nice article – definitely worth reading through. It makes some very good points and raises interesting questions about the wisdom of the crowds.

 

¹ http://www.spectrum.ieee.org

² http://www.spectrum.ieee.org/print/5488