Can prediction markets make it rain?

We have long recognized that the stock market is a Keynesian beauty contest: In the short term, returns don’t come from correctly judging fundamentals. They come from correctly judging how others will judge them.

But value investors take solace in the knowledge that the market is also a Ben-Graham weighing machine: In the long run, fundamentals win out. 

But George Soros says it’s more complicated than that.

In his “general theory of reflexivity,” Soros explains that markets are never passive observers of reality — instead, they actively participate in creating it.

Markets, he says, “affect the so-called fundamentals they are supposed to reflect.”

This makes things much harder for us.

We have to assess 1) what people think the fundamentals are, 2) what the fundamentals actually are, and 3) how people’s thoughts about what the fundamentals are will change the fundamentals.

That makes forecasting stock prices significantly harder than, say, forecasting the weather.

“When you give a bad weather forecast predicting rain tomorrow, it doesn’t make rain tomorrow more likely," Professor Michael Mainelli notes. “But when you give a bad forecast predicting a share will fall tomorrow, you do make it more likely.” 

It’s easy to see how that might happen. A high stock price can be self-fulfilling by lowering a company’s cost of capital, making it easier for management to expand and invest. A low stock price can be self-fulfilling by raising a company’s cost of capital so high they can’t invest at all. 

As such, stock markets are hopelessly entangled with what they’re measuring.

Prediction markets, however, seem to offer a way out.

When stock prices diverge from intrinsic value, the divergence can never be fully resolved — the truth of what a company is worth remains permanently in the future.

Prediction markets, by contrast, resolve to 0 or 1 — the event either happens or it doesn’t — within a defined timeframe (usually a short one).

This should eliminate the beauty-contest dynamic of stock markets: With the truth soon to be revealed, you don’t have to care what other people think. In theory.

In practice, people still do.

In a study of how accurately prediction markets reflect participants’ beliefs, researchers found instead that they shape them: “Traders update beliefs in the direction of observed prices, rather than of the true state.”

That is not how it’s supposed to work! 

We expect traders to push prices in the direction of the truth, but it appears that prices push traders away from the truth.

“A randomly picked individual,” the researchers conclude, “is found to be significantly more informed about the state of the world before observing any market activity than afterward.”

Yikes.

If so, prediction markets will be less like probabilistic weather forecasts than we think and more like self-referential stock prices.

“Prediction markets risk constructing rather than reflecting political realities,” another academic study warns. “Prices that are presumed to reveal collective wisdom may actually amplify perceptions, momentum, and bias.”

In other words, the weather forecast is making it rain again — and this time, the consequences may be more substantial than raising or lowering a company’s cost of capital.

National security expert Matthew Wein warns that “US adversaries and foreign terrorist organizations could exploit [prediction] markets by pairing strategic trades with coordinated information campaigns or cyber intrusions.”

Imagine, say, a malicious actor bidding up the probability of the US invading Greenland — and how the ensuing press coverage might influence the person who decides whether the US should invade Greenland.

Or a US adversary inflating a presidential candidate’s odds of winning — and the doubt and distrust they could sow on social media after the sure-thing candidate unexpectedly loses.

Targeted trading in prediction markets like these could shape news coverage, and therefore public expectations, with unpredictable results.

Prices shape beliefs, beliefs shape behavior, and behavior shapes outcomes.

Wein says this makes prediction markets “dual-use infrastructure”: The same pipes that deliver genuine information about the future can be “weaponized” to deliver engineered narratives intended to shape the future.

If that seems alarmist, recall Soros’s theory of reflexivity: Markets always distort the underlying fundamentals. 

Now consider what’s being distorted: not just stock prices, but elections, geopolitics, military action, Supreme Court rulings…

We built prediction markets to be a weighing machine for all these kinds of things.

They might be a shaping machine instead.

— Byron Gilliam

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