Tuesday, October 28, 2008

The Benefits of Market Forecasts

At this point in the election lead-up, many people probably find themselves focused on the differences between the various projections out there. While the forces of supply and demand sometimes influence Intrade prices in unexpected ways, markets have several advantages over other means of forecasting. None of what I'm going to say is news, but it bears repeating, especially in this environment where people are suspicious of market mechanisms.

First, non-market methods of predicting are vulnerable to over-optimization. If someone fiddles with a model and its weights, they are likely to produce something with an excellent track record in retrospect, but what worked best in the past might not work in the future. Markets can be influenced by well-funded traders, but are less vulnerable to the errors in judgment of isolated individuals.

Second, markets naturally take non-market projections as inputs. If a non-market methodology works well, markets will gradually incorporate its output. While the opposite is possible in theory, someone would need to decide what weights to assign the market and non-market components, which brings us back to the first point. Markets have the advantage of flexibly incorporating all available forecasts.

Many have noted that lack of transparency in asset pricing (not to mention models) played a large role in the credit crisis. Exchange-traded markets provide real-time price transparency, 24/7 in the case of Intrade. Historical price and volume data allow for additional analysis, including detection of when traders may be exercising market power. Non-market methods are likely to only provide a snapshot of their output, making systematic analysis by users
difficult. This may also bias reports of success. If a non-market analysis beats the market, you can be sure you'll hear about it. The opposite is unlikely.

It may be that in the case of elections, poll-based models give markets a run for their money, but that is a specific domain with a relatively rich dataset. It bears noting again that markets provide incentives for uncovering new information, an activity that is quickly reaching maturation when it comes to elections.

Finally, you may not even care about trying to forecast a result you can't control, but markets allow you to control how you are affected by the result. Modernization of regulations in the US will lead to far greater liquidity for prediction markets, which will finally allow for meaningful political hedging. Ultimately, risk-sharing markets may even help to address issues with representative democracies such as the "special interest" problem.

That last bit may sound crazy as I write this in October 2008, but look, ultimately what we are talking about are proper incentives and information aggregation, the lack of which contributed massively to the failure of 20th century communism. If 20th century finance institutions became lacking in the same areas, do you fault "markets" in the abstract?

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