Friday, March 14, 2008

Market backs Ma to win

Big test for Taiwan prediction market

By Jonathan Adams
Asia Times Online, March 14, 2008

TAIPEI - When the first "prediction market" for a Taiwan election was set up in 2000, the result was disappointing.

The market correctly called the election result, but by other measures it was a dud.

"There were only three or four guys who were really doing the trading, and they had really strong biases - one guy favored one party, one was in favor of the other," said Forrest Nelson, a co-founder of the Iowa Electronics Markets, which helped run the Taiwan market. "The fact that it worked at all was a major surprise."

Eight years on, such markets have boomed in popularity. Once the preserve of a few oddball US enthusiasts, they've gone mainstream - and global. They're now used as high-tech crystal balls to help predict everything from soccer scores in Europe to the severity of the flu season in Iowa to the likelihood of Pakistan's President Pervez Musharraf stepping down.

Such markets' growing global appeal is evident in Taiwan, which boasts a new, online Chinese-language prediction market. In contrast to the lonely market Nelson observed, some 2,000 politics fans from Taiwan, mainland China, Hong Kong and elsewhere have already crowded into the new market to trade contracts on who will win the closely watched March 22 presidential vote in Taiwan.

Whether it guesses correctly will be one of the market's first big trials. The election will also test two still-debated points: Do "funny money" markets such as Taiwan's perform as well as ones using real money, and how susceptible are such markets to trader bias?

Taiwan's Center for Prediction Markets, set up in mid-2006, is one of a small but growing crop of Asia-based markets. In Japan, the first political prediction market was set up in 2005; the market now has some 500 registered traders predicting the coming Lower House election. Taiwan also boasts the smaller Taiwan Political Exchange, which correctly called the island's hotly contested 2004 presidential vote.

Like those other prediction markets, The Center for Prediction Markets' works on the model of a futures market, aggregating collective sentiment into one market "price". Except instead of guessing, say, the price of corn three months from now, participants guess the likelihood of a specific outcome (such as a certain candidate winning). Traders start with 100,000 virtual points, which they use to buy and sell contracts. The better their predictions, the more points they rack up.

In the US, such markets have often outperformed public polls, experts say. But they're still struggling to explain exactly why.

One reason is that such markets ask people who they think will win rather than who should win. Another often-cited point is financial incentive. Traders have to put their money where their mouth is, which gives them a stake in making good predictions.

But Taiwan's new market, like most in the US, can't use real money because of anti-gambling laws. That should put it at a disadvantage, right?

Not necessarily. Experts say the jury is still out on whether real money prediction markets outperform "funny money" ones. A 2004 study comparing real and virtual money markets for the US National Football League season found little difference in their predictive powers (both markets' predictions were better than the vast majority of individual predictions).

"People in play money markets act surprisingly similar to people in real money markets because they get some kind of psychic reward for doing well," said Justin Wolfers, a professor at the Wharton School and one of the study's co-authors. Turns out bragging rights can be as strong a motivator as cold cash.

Skeptics have another criticism of Taiwan's market. Its traders include many from mainland China and Hong Kong, who are likely to have a strong bias against Taiwan's pro-independence party. Won't that skew the results in favor of its rival, the China-friendly Kuomintang (KMT)?

Nope again. Traders with extreme and opposing biases can be expected to cancel each other out, experts say, as happened in the 2000 Taiwan prediction market. And traders who are in the game to win (instead of to prove a point or back a party) will rush in to any market thought to be out of whack, whether by manipulation or home-team bias.

"When traders suspect that such manipulation might exist, they will bet on the other side," said Robin Hanson, an expert on prediction markets at George Mason University. "The net effect is that the existence of people who might want to manipulate [the market] usually increases the accuracy of market prices."

Still, no one claims prediction markets get it right every time - they don't. The point, according to what academics call a persuasive body of evidence, is that such markets generally do a better job than predictions by any individual experts or forecasts from public polls.

Outperforming Taiwan's polls shouldn't be hard. They're notoriously bad as a forecast of election outcomes. In late 2006, for example, many media polls underrated the pro-independence party's support - a recurring problem. Taiwan's prediction markets did a much better job of estimating vote shares (the island's two markets both called the Kaohsiung mayoral election wrong, but that contest was a statistical dead heat).

"Most opinion polls usually have 20 to 30% 'no answer'," said Lin Jih-wen, director of the Center for Prediction Markets. "We don't have missing data or a sampling bias, that's our strength."

The market has now picked the strong likelihood of victory by the China-friendly candidate Ma Ying-jeou. Time will tell if it's got the right guy.

But even if it doesn't, the markets' enthusiastic reception shows how Asia - like the US and Europe - has embraced such markets as a powerful fortune-telling tool.

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