Wednesday, November 08, 2006

Are political futures markets really predictive?

Today I will take a brief break from quantitative trading in the financial markets. Instead, I will take a critical look at political futures markets. There has been a lot of enthusiasm lately for such markets (e.g., based in Ireland, is the most popular one.) Media pundits and scholars alike have often said that these markets offer a better prediction of election outcomes than opinion polls, sometimes claiming that they beat polls three-quarters of the time. I have been an avid participant in these markets, but I would like to offer a contrarian view: I believe that these markets often follow, rather than predict, events. The so-called “predictability” of these markets is often ill-defined. The prediction changes constantly over time, and so depending on when you take a snapshot of the markets, you can always find an instant when, retrospectively, the prediction matches the actual election outcomes very closely.

As an example, I watched with amusement the futures market prediction of the Virginia Senate race between Democrat Jim Webb and Republican George Allen. This is one of the two close races that will determine the control of the Senate. For months, the market predicts that the Democrat will lose (the probability of winning, which is the same as the price divided by 100, is always below 50% until the beginning of November). Then in November, the market began to see the light, and started to predict a Democratic win. See the chart below.

But look what happened on the night of the election:

As the vote counts started to be released, the market first thought the Republican was going to win, driving the prices down to the teens. That was due to the votes from the conservative southern Virginia, which were the first to come in. Then, as the vote counts from the more liberal northern Virginia were published at around 11:30 pm, the prices shot up to above $60, and continued on to over $80. Clearly, the market does not know more about the future than your average news anchor.

As someone interested in the predictability of election outcomes based on futures markets, this raises a serious question. What is the proper time to take a snapshot of the market? Should it be 1 month before the election (in which case this market prediction failed, presuming a Democratic win after the recount)? Or should it be 1 week before the election, in which case this market prediction succeeded? And without an answer to this question, how can one claim whether the prediction is accurate or inaccurate?


Unknown said...

I think you have this right. The result for the Presidential election in 2004 was even more dramatic. I doubt the data is still available but I will recount this from memory. As exit polls came out showing a Kerry win the Bush contract went below 10%, then as each piece of news came out over the course of the evening the contract rallied to greater than 90% Bush win likelihood. But as you have observed, that market was following the news, not anticipating it or predicting it.

Anonymous said...

Hi Ernie,
There's a book out entitled "The Wisdom of Crowds" by James Surowiecki which purports to use the aggregated polled results of the public to make informed decisions. Normally, this type of analysis would be used in the stock market in a contrarian fashion, ala Charles Mackay's classic book "The Crowd: Extraordinary Popular Delusions". However, Surowiecki steps the reader through history and shows that polling has positive predictive power when three elements are present: 1)Diversification 2)Independence 3)Proper aggregation of the results.

Here is a summary of the technique:
In a guessing game where participants are asked to guess how many marbles are in a jar, one would assume that the guesses would be distributed randomly and that the mean of the guesses would be somewhat close to the median. Surowiecki argues that when the three elements are present, the mean of the guesses will approximate the actual number of marbles in the jar and beat the majority of individual guesses (median).
I tried the technique by asking the head of the Math Dept. at my daughter's school to get the school wide football pool tallys. After aggregating the individual picks, I found that the mean of the student guesses outperformed 95% of the individual student picks.

Surowiecki argues that the technique is notoriously difficult to apply to the stock market. Any thoughts on applicability?

Steve Halpern

Ernie Chan said...

Hi Steve,
One can certainly argue that at any point in time, the market consensus is the best predictor of the future given the current information, in the sense that it is better than random guesses. The only problem I have is that news has so much impact on the prediction that any advantage over random guesses is not meaningful in a practical sense. This is different from your example of football pool tallys, where I bet that the prediction is fairly stable over time and not subject to daily news releases.

I have not read Surowiecki and so am not sure what he means by applying the technique to the stock market. I thought the stock market is already an implementation of the polling mechanism, and it is the best possible predictor of the future of a company that is available with public information?