Posted by: Ben Steverman on November 3, 2008
Here’s one rare investment that, at least so far, has paid off handsomely in 2008: Barack Obama.
Various election futures markets allow traders to make bets on politics. On Nov. 1, 2007, on the Iowa Electronic Markets, the Illinois senator was given about a 14% chance to merely win the Democratic presidential nomination.
Today, traders are betting Obama has a 90% chance of winning it all by being elected president.
Of course, the Republican nominee, Arizona Senator John McCain, could make a lot of money for certain investors by pulling off an upset on Nov. 4.
As of midday on Nov. 3, the Iowa Electronics Market gives the Republican a roughly 8.8% chance of winning the presidency.
Thus, if you bet on McCain for a “share price” of $8.80, you get a payoff of $100 if he wins. That’s a return of more than 1,000% if you’re right.
Intrade also runs a presidential prediction market: It gives Obama a 92% chance and McCain a 9.5% chance of victory. Another site (not open to U.S. bettors) is Betfair.com, which gives Obama odds of almost 93% and McCain probability of about 8%.
How accurate are these markets?
Many, including the founders of the Iowa Electronic Markets (see video below for more on IEM), say the collective wisdom of traders often beat the accuracy of polls in past elections.
Ben Kunz makes the argument for prediction markets — both in politics and other fields like public health — in this BusinessWeek piece.
On the IEM, you can bet on each candidate’s percentage of the popular vote. Right now, that gives Obama about 53.4% and McCain 46.8% of the vote. A key test of these markets will be how close this is to actual results.
There are plenty of legitimate questions about how well these markets work. This fall, observers alleged that Intrade’s presidential futures market was being manipulated, creating odds that were inconsistent with (and more favorable to McCain than) other markets. Intrade’s CEO John Delaney investigated and said one institutional Intrade member had been making big buys that skewed the market. Delaney said the trader was trying to “manage certain risks.”
Alex Tabarrok at Marginal Revolution didn’t think this called into question the concept of prediction markets:
This supports Robin Hanson’s and Ryan Oprea’s finding that manipulation can improve (!) prediction markets - the reason is that manipulation offers informed investors a free lunch. In a stock market, for example, when you buy (thinking the price will rise) someone else is selling (presumably thinking the price will fall) so if you do not have inside information you should not expect an above normal profit from your trade. But a manipulator sells and buys based on reasons other than expectations and so offers other investors a greater than normal return. The more manipulation, therefore, the greater the expected profit from betting according to rational expectations.
Even if markets get the liquidity they need to work efficiently, they have yet to prove they’re much more than an entertaining parlor game.
If working properly, the markets end up reflecting conventional wisdom. But they don’t really predict the future. A year ago, while Obama was given 14% of winning the Democratic nomination, McCain was given a 7.5% chance of winning the Republican nomination. Both “predictions” weren’t just wrong, but wildly so.
Furthermore, the usefulness of election prediction markets for investors as a so-called “risk manager” is questionable. First, the risks and benefits of an Obama victory should already be reflected in other markets. For example, health care stocks already have been hurt by the prospects for a successful Democratic effort to reform health care. Second, unless you expect to get a job in a McCain or Obama administration, the direct economic effect of a political outcome is not easy to determine. The impact of, say, the Indiana gubernatorial race (which you can also bet on at Intrade) is even harder to detect.
If you’re betting for McCain or Obama, in other words, it’s unlikely you’re trying to hedge against other losses if you lose. Rather, you’re probably just a political junkie having fun and trying to make a little money.
More than 100 million people will vote for president, and each vote will have been determined by a multiplicity of factors. The complexity of it all is mind-boggling. The only thing that comes close to complexity of the factors that influence election vote totals is the many inputs that determine the price movements of a stock or other investment.
And, as the past year has shown in both the presidential campaign and the stock market, life can be very unpredictable.
(Below the jump, a video interview with Joyce Berg, director of the IEM.)