When markets become too confident in markets

Andrew Gelman and David Rothschild have a really interesting piece on some paradoxes that may be arising in the workings of political prediction markets:

Prediction markets took a lot of heat for their prediction on Brexit (holding steady with a predicted probability 25 percent during the week leading up to the vote while polls did not flip from “Leave” to “Remain” until the final day). Probabilistic predictions can and will “fail, ” but it is good to understand why this is happening. Prediction markets have a strong track record and people trust them. And that actually may be the problem right now . . .

Prediction markets have developed an odd sort of problem. There seems to be a feedback mechanism now whereby the betting-market odds reify themselves.

What do we mean by that? In the case of Brexit, it goes like this: Different surveys give different results, and we all know not to trust the polls, which have notoriously failed in various British elections such as the 2014 Scottish Referendum and the 2015 British parliamentary elections. But we do watch the prediction markets, which all sorts of experts have assured us capture the wisdom of crowds.

So, serious people who care about the election watch the prediction markets. The markets say 25 percent for “Leave.” Then there’s other information, the latest poll, and so forth. How to think about this information? Informed people look to the markets. What do the markets say? Twenty-five percent. OK, then that is the probability.

This is not an airtight argument or a closed loop. Of course, real information does intrude upon this picture. But something is amiss when prediction markets stay stable for too long.

In the past, traders followed the polls too closely and sent the prediction markets up and down. But now the opposite is happening. Traders are treating market odds as correct probabilities and not updating enough based on outside information. Belief in the correctness of prediction markets causes them to be too stable. . .

The implication for bettors is that when the odds seem too stable, trade on the news. Don’t assume that the markets have already incorporated all openly available information. Right now the prediction market prices for the presidential election have been incredibly stable for nearly a month, despite waves of news on business scandals, fundraising money, poll swings, and possible indictments. A mature prediction market should show measured, but real, swings in prices in response to news.

Long term, or even medium term, this should right itself; as investors become aware of this bias (in part because of this article!), it should diminish or disappear. But right now, it appears that prediction markets have arrived at a paradoxical place: Their reliability, the very source of their prestige, is causing them to fail.

Read the whole thing.