The Best Is Not Enough

Barry Ritholtz has written a curious column titled The 'Wisdom of Crowds' Is Not That Wise for Bloomberg View, which criticizes prediction markets.  This is not a new view for Ritholtz, as he reminds us by linking to six blog posts critical of prediction markets each written by...Barry Ritholtz.  Indeed Ritholtz has made it his mission to find instances of prediction markets 'failing', and has found six of them.  These include:

• For about two months in 2003, a prediction market expressed there was a 50%-75% that Howard Dean would win the Iowa Caucus...Dean did not win the nomination.
• For most of 2007, a prediction market thought there was a 10%-30% Barack Obama would win the New Hampshire Primary.  Then for about a week before the election, it thought the chance was in the 50%-95% range...Obama lost the New Hampshire Primary.
• In 2005, a prediction market did a poor job forecasting the result of the Michael Jackson trial.  (And so did everyone else.)

Ritholtz's expectation of prediction markets seems to be that they should be perfectly accurate, and when they fail to meet that standard, he dismisses prediction markets as unwise.  But prediction markets aren't trying to be perfect; they generate probabilistic forecasts, meaning they expect to be 'wrong' sometimes.  When a prediction market assigns an 80% likelihoods to events, it expects that roughly one in five won't happen.  So over time, of course there will be some instances where a market leans in one direction and the opposite result occurs.  If you can only find six of these cases over a twelve-year timeframe, you're not looking very hard.

The value of prediction markets is that they're more accurate than other forecasting methodologies, including surveys, data modeling, and gut instinct.  (They're also often cheaper to implement, too.)  Ritholtz utterly fails to demonstrate that any alternative approach is better.  He concludes the following:

I remain unconvinced you can call prices "wise," no matter what market sets them. Perhaps the most constructive comment one can make about the crowd in market prices is that there are no better alternatives yet invented for determining the price of any item to be bought or sold. "The best we've got" hardly rises to the level of "wisdom." (emphasis added)

Here Ritholtz admits that prediction markets are the best tool for forecasting, but nonetheless argues semantics over whether markets are 'wise'.  In my book, using the best tool available is a wise thing to do, so even if the markets aren't wise themselves, people who use them to generate accurate forecasts are.

Ben Golden is a software developer, economist, and evangelist for Inkling Markets.  You can find him on Inkling Markets as benthinkin, and on Twitter, @BenGoldN.