Foretelling the Future: Online Prediction Markets

May 9, 2008 — -- Who will win the Democratic nomination? Who will be the next president? When might Britney Spears go back to rehab? And who will be the next "American Idol"?

Don't look for guidance from TV pundits or gossip magazines. Instead, go to the Web site where people are putting their money where their mouths are: Intrade.com.

Intrade is a futures market, just like commodities markets where people make trades betting on the future prices of things like oil, gold and pork bellies. On Intrade, thousands of people bet on the outcomes of current events.

Here's how it works: If you're convinced that Hillary Clinton is headed for the White House, you can log onto Intrade.com and buy shares betting that she'll get the Democratic nomination. Right now, her share price is low, around 10 cents, because many think it's unlikely she'll be nominated. But if things start looking up for Clinton, more people will buy her shares, and the price of each share will rise. If she actually gets the nomination, each share will be worth a dollar and you will have made a hefty return on your investment.

Putting Political Savvy to Good Use

Bethan and her husband, Jonathan, are political junkies. They talk about politics day in and day out, so when they heard about Intrade, they figured that their political knowledge must be worth something.

"When I found out that we could actually trade on politics, it was like 'What? Why have we been investing in stocks all along?'" Bethan said. "I said to my husband, 'We spend three hours a day talking about politics, we should be able to use this to our advantage.'"

In the fall, John McCain's presidential campaign was running out of money and pundits were saying he'd drop out of the race. His share price on Intrade plummeted to less than 5 cents. If McCain somehow got the nomination, those same McCain shares would be worth a dollar. As Bethan and Jonathan watched a Republican debate in September, they saw a "new confidence" in McCain, and an opportunity to make money.

"Everyone was unloading their shares of McCain on Intrade. But we saw something else in the debate," said Bethan.

They decided to bet that McCain would make a comeback, and of course they were right. Today the McCain shares they bought for around 5 cents are worth 19 times that. The value of Bethan and Jonathan's Intrade account has increased by about $250,000, mostly from betting on McCain.

Now Intrade is more than just a place where people win or lose money making bets. It turns out that the share prices on Intrade can be accurate predictors of the future. Intrade attracts a large and diverse crowd of bettors, and because each participant puts their money on the line, they may be more likely to make careful decisions.

As a result of the collective intelligence of more than 77,000 bettors on Intrade, the prices on the site may be a good way to predict the outcome of current events -- more accurate than some polls and pundits.

In 2004, the market odds on Intrade predicted the presidential vote of every state but Alaska. In 2006, the odds correctly indicated the outcome of every Senate race.

The Wisdom of Crowds

James Surowiecki explained why prediction markets are so accurate in his book "The Wisdom of Crowds."

We have heard bad things about crowds. They're uncontrollable and prone to mob psychology. But under certain conditions, Surowiecki argued, crowds can be wise.

"Even though no one person in the crowd knows everything," Surowiecki said, "if the crowd is big enough and it's diverse enough, you just have access to so much more knowledge than you do if you ask one expert or even a really small team of experts."

You can see this on "Who Wants to Be a Millionaire?" When a contestant is stumped, they can call an expert, usually a smart friend, or they can poll the audience.

"The experts, they do pretty well. They get the answers right about two-thirds of the time," Surowiecki said. "But the audience gets the answer right 91 percent of the time."

The wisdom of crowds isn't limited to game show audiences. The Navy learned about this principle 40 years ago when the nuclear attack submarine Scorpion became lost somewhere in the North Atlantic. The search went on fruitlessly until a Navy man named John Craven assembled a large group of people, from deckhands to captains, and asked them many different questions that would help predict the location of the lost submarine. He didn't just ask them what they thought, he asked to them to bet on it.

"He took all those bets, and put 'em all together, and what he finished with was this kind of map of the ocean floor," Surowiecki said. "And on this map there was this one spot where his team said, 'This is where we think the submarine is most likely to be.' It wasn't anywhere near where the Navy had been looking … and they found it."

The submarine was just 220 yards away from where the bets said it would be.

More recently, officials in the Department of Defense wanted to use the same principle to set up a market that would predict where and when the next terrorist attack would take place, but when the news broke there was an enormous backlash.

"The idea of a federal betting parlor on atrocities of terrorism is ridiculous and it's grotesque," Sen. Ron Wyden, D-Ore., said at the time.

The Department of Defense quickly backed away from the idea and Surowiecki thought that was a mistake.

"These are potentially tremendously useful tools for improving our national security," he said. "It's much more egregious not to use them than to use them."

John Delaney, the founder of Intrade, pointed out that his Web site's data, which predicts the likelihood of such things as earthquakes and bird flu outbreaks, still proves a very powerful predictive tool for a wide range of people.

"The Intrade market data is used by the Navy, it's used by the Federal Reserve, it's used by 50 or 100 universities," he said. "All of these people see a benefit to Intrade and a benefit to the Intrade market data, but still there's confusion as to how -- how your government would treat Intrade."

Delaney has headquartered Intrade in Ireland, and he's hesitant to expand his business into America because our government has passed laws against Internet gambling.

"I've been told I don't look good in an orange jumpsuit," Delaney said jokingly.

Bethan and Jonathan said they're pretty sure that what they're doing is legal, but the law is vague. They understand why prediction markets might have a negative connotation.

"It sounds dirty," Bethan said. "It's politics and money. … It's very taboo."

ABC News contacted the U.S. Department of Justice, but it did not provide a clear answer as to whether Intrade or its users are breaking the law.

Predictions for the Future

Want to know what the markets are saying now? Barack Obama is heavily favored to win the Democratic nomination on Intrade. A share costs 90 cents, indicating a 90 percent chance of winning.

Clinton is trading for just 10 cents. And even though the Illinois senator hasn't won the nomination yet, the crowds on Intrade think Obama has a better chance of winning the presidency than McCain: 56 cents to 38.

Prediction markets have information on much more than politics. On Tradesports.com , another online prediction market, the Boston Celtics are nearly tied with the Los Angeles Lakers to win the NBA championship this year. The Celtics are trading at 30 cents, and the Lakers are at 32.

Over at the Hollywood Stock Exchange, the crowds are saying that "Iron Man" will make the most money of any movie in its opening weeks this year: $286 million. The newest "Indiana Jones" movie is expected to make just under that amount.

You may disagree with these predictions, but odds are that the crowd is right.

As for Bethan and Jonathan, they'll be voting for Obama in November, but on Intrade.com they'll be putting their money on McCain.