Traditional prediction markets resemble stock markets where people can buy and sell predictions to and from each other until some real outcomes are observed and settled.
However, the term is also often used to describe any betting venue that rewards participants in proportion to accuracy, precision and timeliness.
Prediction markets thus provide incentives for both timely and truthful revelation of opinions.
«The most heeded futurists these days are not individuals, but prediction markets, where the informed guesswork of many is consolidated into hard probability.»
In the two decades since the first modern prediction market began operating at the University of Iowa's Tippie College of Business, this form of collective intelligence has produced an impressive track record of accurate forecasting in fields as diverse as business, sports, movies, politics and medicine.
Lumenogic has more than a decade of experience designing prediction markets to help companies improve forecasting, gain customer insights, create idea markets and enhance portfolio management.
It is impossible to quantify the accuracy rate of prediction markets in general, for it of course depends on the intrinsic difficulty of each prediction.
However, as the magazine MIT Technology Review once declared, "in many cases, prediction markets are astonishingly more accurate than other common forms of predictions such as polling, surveys and expert opinions."
Specifically, the data show that:
- Over the long run and many predictions, markets outperform most individuals;
- The more participants there are in a market, the more accurate it is (although there are diminishing returns);
- The more participants there are in a market, the fewer individuals are able to outperform its accuracy.
Prediction markets derive their predictive powers from three sources:
The first source is cognitive diversity. In a nutshell, when dealing with complex issues involving many variables or moving parts, no one can claim to have a complete model or theory from which to make fail-safe predictions. More likely everyone has a partial understanding of the situation, further clouded by his own biases. But when all these partial, biased models are put together, a wonderful thing happens: knowledge accumulates, gaps get filled, while the various biases cancel each other. The group's collective model is better and more complete than any individual model. Prediction markets attract diversity like powerful magnets, because anyone with a model that disagrees with the current consensus has a profit motive to participate in the market.
The second source of market accuracy is that the process encourages the voicing of informed contrarian opinions rather than calculated conformity or respectful consensus. Indeed, the only possibility for profit lies in disagreeing with the consensus, publicly. This makes sure that all informed points of views are included and aggregated. Importantly, the possibility of financial loss also discourages and penalizes the voicing of non-informed opinions.
The third source of market power is that framing predictions as wagers makes people think different, literally: Brain imaging studies show that when it contemplates a gamble, the brain becomes more risk averse and tunes out the emotional signals that might interfere with cognitive performance. In short, our thinking becomes more objective and our judgements less clouded by our passions and preferences.