Betting on the Wisdom of the Crowd

The chance that President Obama will be re-elected is 60%, according to Intrade.com, an exchange where users can make predictions in a wide range of categories. Here are some other predictions at Intrade as of this writing:

• Chances of an air strike on Iran by the US or Israel by yearend: 49.9%
• Chances of a cap and trade system in the US for emissions trading by the end of next year: 10.5%
• Chances of an announcement of the discovery of extraterrestrial life by NASA before the end of 2014: 10%.

Intrade is an online prediction market that allows customers to bet -- with real money -- on world political, entertainment, and financial events. Customers make predictions by buying and selling shares on the outcome of real-world nonsporting events that have an expiration date and a yes-or-no outcome. If you believe that the president will be re-elected in 2012, buy. If not, sell.

Shares are priced from $0 (which means no chance) to $10 (100% likelihood). If someone buys a $6 share in an event that comes true, the share settles at $10. The buyer makes a $4 profit, and the seller loses $4. Buyer profits come from seller losses. If the event doesn't happen, the share settles at $0. The buyer loses $6, and the seller makes a $6 profit. Seller profits come from buyer losses.

Based in Dublin, Intrade The Prediction Market Ltd. has nearly 4,000 active customers, most from the US, who pay a $4.99 monthly fee to participate. The most popular category on the site is politics, especially US politics.

In the Michigan Republican primary today, pollsters have Mitt Romney and Rick Santorum neck and neck, but Intraders put Romney far in the lead. Romney's chances of winning in Michigan: 72.8%. Santorum's chances: 35%.

Romney's campaign has even pointed to Intrade as evidence that the candidate will win in Michigan, which political pundits call a make-or-break state for him, given his history there.

Intraders also say Romney has a 78.6% chance of being the Republican nominee for president, while Santorum has an 8.4% chance.

Intrade's most popular market to date was the 2008 presidential race, where 5.3 million shares were traded. "We expect this record to be broken this year," says Carl Wolfenden, exchange operations manager for Intrade.

Prediction markets are similar to a futures market, where people buy and sell based on what they think the future price of something might be. The market doesn't set odds, and it resembles financial trading, though some view it as a form of gambling.

Intrade isn't the only prediction market out there. Others include the Iowa Electronics Market, which is run by the University of Iowa's Henry B. Tippie College of Business, and the Hollywood Stock Exchange.

At the Iowa Electronics Market, which is primarily a teaching tool, people predict election outcomes using real money. The nonprofit has a $500 investment limit. Most of the roughly 1,200 participants worldwide are policy and political wonks and financial traders, said Tom Snee, a spokesman for the market. "It's still an abstract concept for a lot of people."

At the Hollywood Stock Exchange, people can buy and trade in celebrities and movies using virtual money. Shares of Johnny Depp (JDEPP) and Angelina Jolie (AJOLI) are widely held.

US residents who trade in exchange markets do so in a fuzzy legal area. More on that later. First, how can investors use exchanges like these?

Prediction markets can be used to gauge sentiment on issues that affect various business sectors. If cap and trade seems likely, that might affect companies such as Ford Motor Co. (NYSE: F) and SunPower Corp. (Nasdaq: SPWR), which makes solar cells and panels.

Exchanges can also show how people are feeling about the economy. At Intrade, fewer than 15% of the people think the US will go into a recession this year. That shows some optimism.

Prediction markets operate on the theory that large groups of people collectively analyzing data can speculate more intelligently than an individual. Arguably, they are a smarter crowd, because they do research and are more interested in their market. "The wisdom of crowds is really a powerful tool in predicting things and analyzing events," Snee said.

Exchanges can predict accurately ahead of polls, which are snapshots, he said, but polls can also affect prediction markets.

The "wisdom of crowds" theory also works better if the crowd has real money on the line. The idea is that people who have "skin in the game" will be more inclined to trade rationally instead of emotionally. That idea is fallible, though. People don't always invest money with their heads.

Using prediction markets to get a handle on what people are thinking is akin to the concept of crowdsourcing -- tapping large groups of people for ideas or information. But before you throw out the smart individual, the statisticians, and the economists in favor of the smart crowd, consider the skepticism of Brad Schiller, a professor of economics at University of Nevada, Reno.

Prediction markets aren't scientific models. "They're just gauges of investor sentiment," Schiller said. "The problem is one of timing: How far in advance are the predictions accurate?" It gets easier to make accurate predictions closer to the event, but predictions are more meaningful if they can be made accurately in advance.

Economists are better suited to do that by coming up with economic models that use math and a bit of psychology. Ray Fair, a Yale University economist, has one of the best presidential prediction models, according to Schiller. Fair made his prediction for the 2012 presidential outcome way back in October 2010. Obama will win, according to Fair's model that uses economic variables. The model has been nearly 100% accurate.

The economy is not doing as well as Fair forecast in 2010, but Schiller says the prediction should hold as long as the economy grows by a certain amount in 2012.

What matters is how the economy is faring in the election year, he says. The model takes into account voters' short-term memories. "The bottom line is if the economy grows in any given quarter by 3% or more, Obama wins handily."

The legality of exchanges that use real money is a bit fuzzy. The Iowa Electronics Market has a "no action" letter from the Commodities Futures Trading Commission, a federal agency that oversees futures trading organizations. Snee says no action means the agency won't regulate the exchange.

Intrade operates under Ireland's jurisdiction. It's illegal for US residents to use US banks and credit cards to fund accounts for making bets online, but it is unclear whether exchanges are considered gambling.

Furthermore, a recent ruling by the Department of Justice modified its interpretation of the Wire Act of 1961, removing prohibitions against many online games. The ruling, which says the Wire Act applies specifically to sports-related gambling, opened the door to opportunities for the online gaming industry.

"All exchange member related information is completely confidential and protected under Irish law," Intrade's Wolfenden said in an email. "It is our policy, partly due to the ever changing nature of national and regional laws, to never offer legal opinions on what is legal or otherwise in other jurisdictions. Our members are responsible for ensuring their activities are legal."

So far, prediction markets have operated with little scandal or interruption from federal regulators or law enforcement agencies. What's your prediction on how long that smooth operation will last?