The Elegance of Prediction Markets
Plus Gambling Culture, Better Decision Making, & a History of Crypto
Welcome to episode two of Arrowhead Insights. Today, we’ll cover why prediction markets were so accurate in forecasting the presidency, a better way to make and evaluate decisions, and close with a book review on the history of crypto. Let’s dive right in.
The Elegance of Markets
Gambling culture is everywhere. It’s difficult to peg the origin of the movement, but the 2018 New York Times article “Everyone is Getting Hilariously Rich and You’re Not” feels like a safe place to start. The FOMO-inducing vibe of that first crypto wave had people rushing to learn about blockchains and why no one in the industry knew how to spell HOLD correctly.
In the succeeding years, we witnessed the massive meme stock phenomenon and degenerate “investing” activity into stocks like Gamestock and AMC courtesy of the subreddit Wall Street Bets. A community member even had to testify in front of Congress about his activity in promoting stocks.
Sports betting ads are ubiquitous, experts are paid to produce content forecasting the color of Gatorade in the Super Bowl, and it feels like we’re still in the early innings.
Most recently, election prediction markets have been making major headlines. For the first time, there was a mainstream way to bet on who will become president. The impact was tangible. Polymarket and Kalshi, two popular prediction market platforms, were the most downloaded apps leading up to November 5th. A mystery trader sent the market searching for answers after he bet $30 million on a Trump win (more on him later), and election night results mirrored what betting markets predicted a week earlier.
While the prediction markets were imperfect, they were quicker to call races and produced more actionable insights than traditional polling systems. Why were the results so accurate? How does that tie into investing? Let’s go back to the early 20th century to find out.
A Quick Stop at the Fair
Let me introduce you to Sir Francis Galton.
In 1906, this handsome guy attended a country fair in England and arranged a contest. He took a large group of people from various backgrounds - farmers, butchers, cobblers - and gathered them around to guess the weight of an ox. Their guesses varied, as you might imagine, from widely inaccurate to seemingly reasonable. Galton calculated the average guess to be 1,197 pounds.
Galton was skeptical of what he thought would be inaccurate guesses from the general public. He assumed that individuals with no expertise in livestock would make poor estimates, resulting in a predictably inaccurate result. To his surprise, however, the collective estimate proved almost perfect. The ox weighed 1,198 pounds, 0.08% off from the average guess.
Why Did We Go to the Fair?
Good question. Galton’s discovery was a tipping point in the recognition of the wisdom of crowds. The idea is that the viewpoint of an individual can inherently be biased, whereas taking the average knowledge of a crowd can result in eliminating the bias or noise to produce a clearer and more coherent result.
Today, we see this in qualitative formats such as Reddit and Wikipedia (thanks in part to the brave crusaders correcting incorrect information online), as well as quantitative ecosystems like financial markets.
Its influence on finance is most pronounced in the Efficient Market Hypothesis (EMH). The theory states that it’s virtually impossible to beat the market consistently, as all the information relevant to stocks is already reflected in their current price. It’s an assertion that stocks are always trading at their fair market value, as any deviations would be quickly corrected by buyers and sellers settling at the true value. As the old joke goes:
A young economist looks down and sees a $20 bill on the street and says, "Hey, look a twenty-dollar bill!"
Without even looking, his older and wiser colleague replies, "Nonsense. If there had been a twenty-dollar lying on the street, someone would have already picked it up by now."
While there are various belief tiers in this concept and staunch dissentients, it’s a good heuristic for anyone outside of the world of finance to follow. As Warren Buffet has demonstrated in his public wager with a hedge fund, it’s generally a positive expected value bet that investors will fail to beat the market.
Prediction Markets Breed Efficiency
Money is one of history’s greatest motivators. While there’s no shortage of people willing to defend their truths for free on the internet, the ability to generate a profit opens the doors to more researched and well-funded examinations.
Historically, election analysis was reserved for political groups and secretive hedge funds. Sam Bankman-Fried of FTX infamy, for example, worked on a model for the quantitative hedge fund Jane Street before his crypto days, which correctly predicted the outcome in 2016.
However, armed with the ability to wager on prediction markets for the first time, individuals and new participants are willing to step into the arena. Believing that traditional polling methods are flawed, the mystery trader mentioned earlier invested upfront capital to commission his own survey to take the nation's temperature. The findings pointed him in the correct direction - he’s set to make $50 million from the results.
His efforts, and those from the likes of Jane Street, work to arbitrage away any edge that exists in markets. Mispricings represent opportunity, and investors are financially incentivized to buy enough securities to return prices to their true market value. They’ll continue to employ resources to hunt down winning trades for as long as it is profitable.
To that end, to the degree more trading platforms become available and gambling culture breeds more motivated participants, markets will become more efficient.
Diving Deeper: Better Information & Better Decisions
There are occasionally $20 bills on the floor. Markets are not infallible, and mispricings exist. Yet, in a world where information is more readily available than ever before, it's healthy to approach any perceived opportunity with a dose of skepticism - especially if there’s not a clear reason why you are uniquely equipped to recognize the anomaly.
It’s also important to remember that knowing the future does not always mean making a profit. Jane Street lost $300m on its bets even with the model’s correct projections (it incorrectly forecasted how the market would respond to the news). Our French mystery trader may not have a happy ending either, as regulators are examining his bets since Polymarket is illegal in the country. It turns out it’s hard to beat the market, even if you have the inside scoop.
Content Corner
We’re turning to the archives to tie in a valuable theme with the above. Annie Duke, a world poker champion who holds a doctorate in cognitive psychology, released Thinking in Bets in 2018. This podcast episode recaps many of the key points in the book and is as pertinent now as it was when it was first released.
Duke articulates the concept of “resulting” - the error of evaluating decisions based purely on outcomes instead of the decision process itself. In effect, we should be focused on whether a choice was a good one, independent of the result.
Resulting, or having an “outcome bias,” is misleading because the fruits of our decisions are influenced by randomness and factors beyond our control. This means that even well-thought-out decisions can lead to poor outcomes, and poor decisions can sometimes result in favorable outcomes.
It’s important not to gloss over the latter point. Just as we should not evaluate ourselves solely on the results of our decisions (caveat emptor), we should keep in mind that plenty of successful people are simply lucky. Consider this a healthy reminder that survivorship bias is everywhere.
Survivorship bias is the logical error that occurs when we focus on “successful” individuals or things that made it through a situation and ignore others that didn’t. The famous example is a WWII analysis where planes were analyzed after returning home after receiving enemy fire. An initial thought would be to add extra protection to the areas with the red dots, as those were the ones that got hit the most. After accounting for survivorship bias, however, its clear the areas that weren’t hit needed the most reinforcement. The planes hit there were the ones that didn’t make it home.
Duke’s work overlaps with fellow poker player Nate Silver’s book (which we covered last edition), though it is more practical than narrative-driven. It's a worthwhile exploration for anyone looking to improve their decision-making and reduce the effort exerted in making and evaluating decisions. For the readers of the group, a transcript of the podcast is available here.
Book Review
Nonfiction that reads like fiction is my favorite genre, and Number Go Up by investigative journalist Zeke Faux fits the category like a glove. It’s a window into the truth-is-stranger-than-fiction world of crypto and how it has managed to have such a profound impact on the world.
Faux went all out, including buying a $20,000 NFT to attend one of the exclusive “ApeFest” parties punctuated by a Snoop Dogg performance. The journey includes time in El Salvador, where he learns about what happens when a world leader wagers its treasury on Bitcoin, as well as Cambodia, where he uncovers astounding atrocities related to “pig butchering” scams. He breaks down the inner workings of the stablecoin Tether and how the people of the Philippines have been impacted by the failure of the game Axie Infinity to deliver on its promises.
At points, the work is heavier than I expected. The portions detailing what has happened in developing nations are a firm reminder of how interconnected our world is and how scams can run much deeper than your neighbor losing a bit of money.
The impact crypto has had on financial markets and investing is undeniable, and I have yet to find a more comprehensive articulation of its history and impacts than this book.
Parting Piece of Philosophy
“Good and evil both increase at compound interest. That is why the little decisions you and I make every day are of such infinite importance. The smallest good act today is the capture of a strategic point from which, a few months later, you may be able to go on to victories you never dreamed of.” -C.S. Lewis, Mere Christianity
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The information posted on Arrowhead Insights does not constitute financial advice. The views expressed are my own and do not represent any organization. All content provided is for informational purposes only.