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Our good friend Barry Ritholtz.has persuaded himself that our real-money prediction markets suffer from an irremediable and fatal problem: liquidity on political event derivative markets is too thin for smart Wall Street people like him to take their market-generated probabilities seriously. Barry Ritholtz is keen to tout oranges–-apples comparisons: the NYSE volume versus the Obama–-Clinton volume at InTrade. It’-s a bullshit argument, but he managed to persuade some gullible journalists writing for some clueless mainstream media that thin liquidity was responsible for the New Hampshire upset —-and else.
Barry, if you had 1,000,000,000 trades on the New Hampshire prediction market, you’-d still have an inaccurate prediction. The polls were wrong, and there’-s nothing …- NOTHING…- that the InTrade and BetFair traders could have done to get this election right. Get over it, Barry. Traders are not magicians. 
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[For why the polls were wrong, see: The New York Times, Zogby, Rasmussen, Gallup…]
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While it is true that traders are no “magicians,” it is generally accepted in financial markets that the heavier the volume, the more you can count of a result being the true indication of market price. Intrade’s volume has a long, long way to go before it can withstand even just $10k worth of bets without moving significantly.
Now we get to the crux of the issue here –
We are in agreement that very often, markets fail to forecasts the result of specific events or outcomes. There are a variety of academic reasons as to why this is so.
According to Legg Mason’s Michael Mauboussin, one needs diversity, aggregation, and incentives – and I agree.
that is in a nutshell the problem with these smaller markets: one only achieves a broad diversity through a significant number of traders; one only attracts a large number of traders, through significant incentives; and by significant incentives I mean trillions not thousands of dollars.
Hence, the occasional failure of a prediction market, based on the relative small size, modest incentives, and lack of broad aggregation is neither the failure of magic nor markets: it is merely the inevitable outcome of the lack of size and volume these markets have.
Increase the volume, traders, and dollars at stake, and you will likely see an increase in accuracy.
@Ashish Singal: When it comes to divining the future, higher volumes won’t help when the polls are wrong.
@Barry Ritholtz: I disagree. To increase the absolute accuracy of the InTrade and BetFair prediction markets in the area of politics, what you need is to increase the accuracy of the polls —which is what the traders look at.
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Gallup et al., only, can help the prediction markets.
[…] I have been telling that to Barry Ritholtz —but he stays on his position. […]