Hedging Your Bets on Current Events

Can Markets Really Predict the Future?


April 2, 2008—

The chance Vice President Dick Cheney resigns during his second term? Three percent. The chance Democrats retain control of the Senate after this year's elections? Ninety-one percent. The chance gas prices hit $4 per gallon before July 1? Thirty-three percent. Or so the traders at NewsFutures think.

NewsFutures.com is an Internet-based news prediction market that operates much like the stock market. Using a fake currency called X$, participants buy and sell shares at prices ranging from X$1 to X$100 in events like "the Dow will rise on 4/2" or "the Boston Celtics will win the Eastern Conference title." These contracts are sold alongside shares for the opposite outcomes. If the event occurs, the shareholder receives X$100 for each share.

The trading price of each share represents the probability traders collectively assign to the event occurring. If "President Bush will pardon Scooter Libby" is trading at X$73, for instance, it means participants believe there is a 73 percent chance the president will pardon Cheney's former chief of staff for his perjury conviction.

NewsFutures creator Emile Servan-Schreiber believes that prediction markets like his are the "future of journalism."

"It gives people the news of today and lets them give you the news of tomorrow in a probabilistic fashion by asking them to take bets on what is going to happen," Servan-Schreiber said.

Servan-Schreiber founded News Futures Inc. — the parent company of the NewsFutures exchange — in 2000. The site now operates in the United States, France and Hungary. Its several thousand active traders generate millions of hits each month.

Servan-Schreiber believes his Web site fills a void in online media. Before NewsFutures was founded, "the media Web sites were just dumping their regular content on the Web in a non-interactive way," he said.

Servan-Schreiber thinks that NewsFutures provides this interaction, although it's not the first to utilize idea markets.

The Birth of Idea Markets

Robin Hanson, a George Mason University assistant professor of economics, is largely credited with pioneering the concept of "idea markets." Hanson envisioned them as exchanges where scientists staked money on the validity of new theories. He hoped the markets would help scientists build a consensus around new theories based on their merits, rather than whether the ideas were trendy.

Hanson first publicized idea markets in the 1990s and, since then, a number of groups have integrated them into their operations. Many businesses use prediction markets to forecast the price of raw materials or gauge their employees' expectations of product delays.

In fact, NewsFutures sells forecasting market technology to companies such as Pfizer, Frito Lay, Renault, Arcelor and Siemens. According to Business Week, Yahoo also used an internal prediction market in 2006 to assess the worthiness of new products and services that employees suggested.

Prediction markets have also been applied outside the business world. In 2003, the U.S. government even launched its own abortive market, the Policy Analysis Market (PAM).

PAM was designed to gather intelligence through a prediction market in assassinations, coup attempts and instability in the Middle East. PAM would have worked much like NewsFutures. Traders, using real money, would have been able to buy and sell shares in events such as "the king of Jordan will be overthrown" or "the U.S. will recognize Palestine as an independent nation," in order to help intelligence analysts assess the probability of those events occurring.

The Bush administration ultimately killed the PAM program under withering criticism after details of the program became public. Opponents labeled the program an "assassination market" and "grotesque." Before PAM's termination, Hanson worked to help design the program.

"It was disfigured by the media," Servan-Schreiber said. Nevertheless, "the PAM mishap created enormous visibility for the industry."

Trusting the Crowds

While the money earned on NewsFutures isn't real, Servan-Schreiber argues that prediction markets are an incredibly valuable tool.

"I think of them as a brain," he said. "You take a bunch of individually stupid neurons and put them together. Through massive interaction emerges intelligence. It's the same thing with the market."

"The market really is smarter than the average player in there, and sometimes smarter than anyone in there, even the best player," he said. This aggregation of many people's opinions, Servan-Schreiber argued, produces an "incredible probability that the market prices really corresponds to the probability [of the event occurring]."

But not everyone is sold on the accuracy of prediction markets. Critics like Barry Ritholz, the CEO of the online quantitative research firm Fusion IQ, say that traders sometimes make wildly inaccurate predictions because they don't wager a lot or any money.

In early 2008, NewsFutures and many other markets placed the probability of Sen. Barack Obama winning the New Hampshire primaries at more than 80 percent. His opponent for the Democratic presidential nomination, Sen. Hillary Clinton, won.

"Since the amounts at stake are small, the incentive is minimal or perhaps non-monetary," Ritholz wrote on his popular financial blog "The Big Picture." "Maybe this attracts a somewhat more politically passionate — and less objective — group of traders."

Servan-Schreiber doesn't believe that small stakes lead to inaccurate predictions.

"If you know nothing, you don't participate," he said. "It's self-selection all the way. If you think you know something, and you don't, you get eliminated very quickly."

In a study Servan-Schreiber conducted with Justin Wolfers, an assistant economics professor at the University of Pennsylvania, and two others, he found that NewsFuture traders accurately predict the probabilities that NFL teams will win games, despite the fact that they wager no money.

Even among the NewsFutures traders, there is no consensus on the value of the predictions they collectively make. NewsFutures' most successful trader, a 37-year-old attorney who wished to be known only by user name azriel0, doesn't trust them.

"Crowds are not smart; crowds are stupid. Crowds riot and loot," azriel0 said. "Crowds mindlessly forward chain letters and spam virus e-mails. Give me the reasoning, knowledgeable individual over the crowd any day."

One of the site's administrators whose user name is gobuckeyes strongly disagreed.

"'The Wisdom of Crowds' can't be denied," wrote gobuckeyes, a U.S. Navy veteran in his 50s, referring to a popular book by the journalist James Surowiecki. "Prediction markets are not just a fun game; they are a valuable industry tool. If you can receive [an] opinion from your consuming public and mesh that with the opinion of your consultants," he argued, businesses will get "a more rounded set of data from which to decide that product's future."

Though the men, who have each played for about five years, disagree over the value of their predictions, both know the reason people keep coming back: Trading in the news is fun.

"It's some combination of feeling wins and losses without risking money, accumulating something, and chatting with people who are like themselves," azriel0 explained.

Servan-Schreiber hopes this enthusiasm continues to spread and that these markets keep expanding, reaching new people with different ideas.