If prediction markets are efficient, no one should use them (how they are currently being used). This is something that has bothered me for a while about the claims with prediction markets, particularly when compared to equity markets. Prediction markets are fundamentally a negative sum game (since you lose fees/interest taken by the platforms). If they were efficient (i.e., the price reflects all available information accurately), then you should in general always expect to lose in the long run if you don’t have any private information. Equity markets have an obvious advantage of generally being a net positive, since they reflect the value of underlying firms/assets which tend to increase in value.
Of course, the more obvious closer comparison is to financial derivatives. In theory, I do see a strong case for prediction markets as effectively more direct methods of exchanging and managing risk (similar to how financial instruments like interest rate swaps are used). But the reality is pretty much no one using prediction markets trades that way, and indeed people advocating for the use of prediction markets generally discourage using them that way (e.g., a common case made by those like Hanson is that you should bet on things you expect and desire to happen so you have a vested interest in the outcome, this is the exact opposite of what you would do if you were using them as risk management tools, in that case you would want to bet against the outcome you most expect and are making other financial decisions on so that in the case you are wrong the damage is mitigated).
Isn’t a natural conclusion then that in reality prediction markets are not completely efficient? There are subsidy, irrational traders/gamblers, and risk hedging (yes I know you mentioned it).
Subsidy can come in another form, a player can spend money trying to elicit information so that they can use the information somewhere else.
Also efficiency can be relative to a trader even if everyone only trades on public information because in reality no one has the time to discover and aggregate all the public information. This is just wrong
Also efficiency can be relative to a trader even if everyone only trades on public information because in
I’ll be blunt and start here, as it is an important mistake I see made a lot. I think a lot of people misunderstand what market efficiency refers to. It has nothing to do with individual trader behavior. You could be seeking out the worst investments, that wouldn’t matter to the question of how efficient the market is. Market efficiency is just about the price. To the extent the price accurately reflects available information (or the underlying fundamental value) the market is efficient. An individual traders behavior is entirely irrelevant.
Also, efficiency doesn’t equate to “good” so it can be a bit misleading. You could say roulette is 95% efficient, since the price is just off by ~5% of the underlying value (which can be ascertained by available information). But there isn’t any way for you to reliably capture that 5%, it is off because of value captured by the house. And, like prediction markets, roulette is a negative sum game.
Isn’t a natural conclusion then that in reality prediction markets are not completely efficient?
Sure, hence the “if” in my original comment. If you are doing it because you like to gamble, that’s fine. Risk hedging also theoretically makes sense, but isn’t currently how the markets are being used in any meaningful aense (and as mentioned runs dirextly contrary to how proponents like Hanson often suggest they should be used).
If you think the average traders are predictably irrational it should be possible to take their money and enrich the platform in the process. That seems like a bad thing and a good reason to advocate against prediction markets. Negative sum games are not exactly great for the economy, and anyone with altruistic views should view negative sum games as definitionally net negatives, I would argue.
Proponents of prediction markets generally argue they are efficient markets. If they aren’t, the utility generally claimed to exist isn’t there.
Subsidy can come in another form, a player can spend money trying to elicit information so that they can use the information somewhere else.
Spending money doesn’t gain information. As I mentioned in my other comment. There is no additional price discovery function you can access to by placing a bid or ask on a prediction market. To the extent the market has that value, it is independent of your transactions.
I think I am implicitly just saying that prediction markets are not perfectly efficient. I think that is normal and still have great utility, I don’t think efficient markets are something to be worried about because they will only exist mathematically. All these behaviors that only make sense when the market is not efficient makes sense exactly because the market is not efficient. But, there are different degrees of inefficiency. It is a scale, and I think prediction markets are pretty accurate already even if it is not mathematically efficient. Have you seen the brier score on different prediction markets? They are obviously not perfect, but it is pretty close. Close enough that it sometimes makes sense to act as if market probability = true probability.
Also the prediction markets are not negative sum for society as a whole, the fee doesn’t just evaporate. It simply goes to the platform. Taking money from dumb people in a zero-sum game is fine.
Subsidy can come in another form, a player can spend money trying to elicit information so that they can use the information somewhere else.
Again I am assuming an imperfect world. There are a lot of public information but you don’t want to spend time aggregating them, instead you create a market and put $10k in the automatic market maker to incentivize people to make their best guess.
just saying that prediction markets are not perfectly efficient
I wouldn’t say anyone is really discussing perfect efficiency. You could reasonably say roulette is a fairly efficient market, the price accurately reflects 95% of the value.
There isn’t really value you can reliably, fairly make off them (otherwise someone like Jane Street would probably have scooped it up). You may be able to make money in some, but odds are more likely than not you are wrong and the juice isn’t worth the squeeze.
Close enough that it sometimes makes sense to act as if market probability = true probability.
Yes, and if that is the case, your chances are greater than not that no matter how intelligent you are if that is true using a prediction market will lose you money.
still have great utility
What, though? The main valid arguments for utility i see—risk management and price discovery—are not how the platforms are being used or not good reasons to trade (on current platforms) respectively. To be clear, I think there are valid arguments for utility in potential, but what is currently being promoted by proponents in extant markets doesn’t match the potential utility.
instead you create a market and put $10k in the automatic market maker to incentivize people to make their best guess.
In theory, maybe. In reality, doesn’t happen on any current platforms. To the extent they adopt automatic market makers, those market makers act more as bookies, providing liquidity only at prices in excess of reasonable fair odds. Some play money platforms use automatic market makers designed to encourage price discovery (which Hanson has advocated for) but I am not aware of any large prediction markets that do so.
Also the prediction markets are not negative sum for society as a whole, the fee doesn’t just evaporate
They have costs and there still is time value issues (to be truly net-zero, the total value of any position on average would have to appreciate by the risk-free rate + a risk premium), so it is still a net negative sum in that sense.
But I was talking from the perspective of a person trading, not society as a whole.
Taking money from dumb people in a zero-sum game is fine.
I don’t necessarily think so. Like, a lot of scams are zero sum, but I would say scamming people is still wrong (even in cases where it might not legally be fraud). Taking advantage of people being gullible or gamblers is generally something I would not view favorably, and where there is a net loss (as is the case with, say, gambling at a casino) my default is to take a rather skeptical view.
In the case of equity, there is the fairly valid claim that it determines how equity is allocated, and by definition more efficiently allocating equity leads to greater economic product and therefore a net positive (and equity tends to increase in value above the risk free rate). Traders in prediction markets aren’t really doing that; they are not capital markets.
I didn’t mention it, but of course another benefit a lot of proponents reference is price discovery. This is certainly a real benefit (though, I am a bit skeptical about some of the claims of the extent of utility), but as an individual not a good reason to trade. I have seen some, like Scott Alexander, argue that platforms will pay traders to use them. This seems facially implausible to me and not clear how it would be structured. But in any case, it isn’t how the platforms actually work (some do pay interest on positions, but they pay less than the risk-free rate).
Also, some have argued for actually encouraging insider trading, since allowing insiders to trade will make the prices even more accurate predictions. Even if we grant this argument, this makes it even worse reason for a typical trader to enter the market. It would mean paying a premium to play an unfair game, paying to get worse odds seems inherently non-sensical.
If prediction markets are efficient, no one should use them (how they are currently being used). This is something that has bothered me for a while about the claims with prediction markets, particularly when compared to equity markets. Prediction markets are fundamentally a negative sum game (since you lose fees/interest taken by the platforms). If they were efficient (i.e., the price reflects all available information accurately), then you should in general always expect to lose in the long run if you don’t have any private information. Equity markets have an obvious advantage of generally being a net positive, since they reflect the value of underlying firms/assets which tend to increase in value.
Of course, the more obvious closer comparison is to financial derivatives. In theory, I do see a strong case for prediction markets as effectively more direct methods of exchanging and managing risk (similar to how financial instruments like interest rate swaps are used). But the reality is pretty much no one using prediction markets trades that way, and indeed people advocating for the use of prediction markets generally discourage using them that way (e.g., a common case made by those like Hanson is that you should bet on things you expect and desire to happen so you have a vested interest in the outcome, this is the exact opposite of what you would do if you were using them as risk management tools, in that case you would want to bet against the outcome you most expect and are making other financial decisions on so that in the case you are wrong the damage is mitigated).
Isn’t a natural conclusion then that in reality prediction markets are not completely efficient? There are subsidy, irrational traders/gamblers, and risk hedging (yes I know you mentioned it).
Subsidy can come in another form, a player can spend money trying to elicit information so that they can use the information somewhere else.
Also efficiency can be relative to a trader even if everyone only trades on public information because in reality no one has the time to discover and aggregate all the public information.This is just wrongI’ll be blunt and start here, as it is an important mistake I see made a lot. I think a lot of people misunderstand what market efficiency refers to. It has nothing to do with individual trader behavior. You could be seeking out the worst investments, that wouldn’t matter to the question of how efficient the market is. Market efficiency is just about the price. To the extent the price accurately reflects available information (or the underlying fundamental value) the market is efficient. An individual traders behavior is entirely irrelevant.
Also, efficiency doesn’t equate to “good” so it can be a bit misleading. You could say roulette is 95% efficient, since the price is just off by ~5% of the underlying value (which can be ascertained by available information). But there isn’t any way for you to reliably capture that 5%, it is off because of value captured by the house. And, like prediction markets, roulette is a negative sum game.
Sure, hence the “if” in my original comment. If you are doing it because you like to gamble, that’s fine. Risk hedging also theoretically makes sense, but isn’t currently how the markets are being used in any meaningful aense (and as mentioned runs dirextly contrary to how proponents like Hanson often suggest they should be used).
If you think the average traders are predictably irrational it should be possible to take their money and enrich the platform in the process. That seems like a bad thing and a good reason to advocate against prediction markets. Negative sum games are not exactly great for the economy, and anyone with altruistic views should view negative sum games as definitionally net negatives, I would argue.
Proponents of prediction markets generally argue they are efficient markets. If they aren’t, the utility generally claimed to exist isn’t there.
Spending money doesn’t gain information. As I mentioned in my other comment. There is no additional price discovery function you can access to by placing a bid or ask on a prediction market. To the extent the market has that value, it is independent of your transactions.
I think I am implicitly just saying that prediction markets are not perfectly efficient. I think that is normal and still have great utility, I don’t think efficient markets are something to be worried about because they will only exist mathematically. All these behaviors that only make sense when the market is not efficient makes sense exactly because the market is not efficient. But, there are different degrees of inefficiency. It is a scale, and I think prediction markets are pretty accurate already even if it is not mathematically efficient. Have you seen the brier score on different prediction markets? They are obviously not perfect, but it is pretty close. Close enough that it sometimes makes sense to act as if market probability = true probability.
Also the prediction markets are not negative sum for society as a whole, the fee doesn’t just evaporate. It simply goes to the platform. Taking money from dumb people in a zero-sum game is fine.
Again I am assuming an imperfect world. There are a lot of public information but you don’t want to spend time aggregating them, instead you create a market and put $10k in the automatic market maker to incentivize people to make their best guess.
I wouldn’t say anyone is really discussing perfect efficiency. You could reasonably say roulette is a fairly efficient market, the price accurately reflects 95% of the value.
There isn’t really value you can reliably, fairly make off them (otherwise someone like Jane Street would probably have scooped it up). You may be able to make money in some, but odds are more likely than not you are wrong and the juice isn’t worth the squeeze.
Yes, and if that is the case, your chances are greater than not that no matter how intelligent you are if that is true using a prediction market will lose you money.
What, though? The main valid arguments for utility i see—risk management and price discovery—are not how the platforms are being used or not good reasons to trade (on current platforms) respectively. To be clear, I think there are valid arguments for utility in potential, but what is currently being promoted by proponents in extant markets doesn’t match the potential utility.
In theory, maybe. In reality, doesn’t happen on any current platforms. To the extent they adopt automatic market makers, those market makers act more as bookies, providing liquidity only at prices in excess of reasonable fair odds. Some play money platforms use automatic market makers designed to encourage price discovery (which Hanson has advocated for) but I am not aware of any large prediction markets that do so.
They have costs and there still is time value issues (to be truly net-zero, the total value of any position on average would have to appreciate by the risk-free rate + a risk premium), so it is still a net negative sum in that sense.
But I was talking from the perspective of a person trading, not society as a whole.
I don’t necessarily think so. Like, a lot of scams are zero sum, but I would say scamming people is still wrong (even in cases where it might not legally be fraud). Taking advantage of people being gullible or gamblers is generally something I would not view favorably, and where there is a net loss (as is the case with, say, gambling at a casino) my default is to take a rather skeptical view.
In the case of equity, there is the fairly valid claim that it determines how equity is allocated, and by definition more efficiently allocating equity leads to greater economic product and therefore a net positive (and equity tends to increase in value above the risk free rate). Traders in prediction markets aren’t really doing that; they are not capital markets.
I didn’t mention it, but of course another benefit a lot of proponents reference is price discovery. This is certainly a real benefit (though, I am a bit skeptical about some of the claims of the extent of utility), but as an individual not a good reason to trade. I have seen some, like Scott Alexander, argue that platforms will pay traders to use them. This seems facially implausible to me and not clear how it would be structured. But in any case, it isn’t how the platforms actually work (some do pay interest on positions, but they pay less than the risk-free rate).
Also, some have argued for actually encouraging insider trading, since allowing insiders to trade will make the prices even more accurate predictions. Even if we grant this argument, this makes it even worse reason for a typical trader to enter the market. It would mean paying a premium to play an unfair game, paying to get worse odds seems inherently non-sensical.