All seeing all knowing
Futures markets can help identify successful products, predict revenues, and even forecast whether Bush or Kerry will win in November
The Pentagon came under fire last summer for its plan to launch a futures market where traders could wager on the likely occurrence of various economic and geopolitical events in the Middle East, including terrorist acts. The program's goal was to harness the predictive powers of markets in order to get a better analytical handle on a maddeningly complex region of the world--and perhaps prevent another 9/11. But whatever the intent, to many observers the whole idea seemed in poor taste. When plans for the Policy Analysis Market hit the news, headline writers quickly dubbed it "the terror market," and New York Sen. Hillary Rodham Clinton branded it a "futures market in death." But supporting the adage that there's no such thing as bad publicity, prediction markets live on--in the private sector.
"There has been a huge surge of interest since the Pentagon controversy last year," says Emile Servan-Schreiber, CEO of NewsFutures, a firm that develops prediction markets for businesses. "These markets got killed politically, but intellectually there was a huge rally in the defense of them, and we started fielding a lot of leads from companies who wanted to try this." Among the firms tinkering with prediction markets to help their decision making and forecasting are Eli Lilly, HP, and Dentsu, Japan's largest advertising agency. In the future, these markets could help forecast everything from corporate earnings to drug approvals to employee retention rates.
Executives at those companies apparently dissent from Danish existentialist philosopher Soren Kierkegaard, who wrote, "Wherever the crowd is, there is untruth." At the heart of these markets is the belief that there is plenty of truth to be found in crowds, that the wisdom of many is often superior to that of one, even an expert. The problem, though, is determining the consensus opinion. This is where prediction markets come in. "There's an old saying that 'All of us know more than any of us,' " says Thomas Malone, a professor at the Massachusetts Institute of Technology's Sloan School of Management and author of The Future of Work, which, among other things, explores the value of prediction markets to business. "Prediction markets help make this old saying a reality. They combine what lots of individuals know into a single consensus view that is usually much more accurate than any of the individual views."
With prediction markets, also called "betting markets" or "idea markets," the current odds or price levels constitute the best available consensus about a particular question. Some of the most well-known and accurate prediction markets are the Iowa Electronic Markets, run by the University of Iowa's business school, where traders speculate about a variety of political and financial forecasts. With IEM's Presidential Vote Share Market, for instance, political junkies can invest as much as $500 in futures contracts based on what percentage of the popular vote President Bush and Sen. John Kerry will each get on Election Day. Currently, each $1 contract is going for around 50 cents, which means the market is predicting a dead-even contest (chart, Page 56).
The superior performance of the Iowa market reflects one reason why these predictive exchanges work better than simple opinion polls. The people who trade are self-selected, political know-it-alls who are likely to follow the presidential race far more closely than the average voter who gets contacted by a pollster like Gallup or Zogby. In addition, says Malone, "the participants have a clear self-interest in predicting what will really happen rather than what they want to happen or what they want someone else to think will happen." In this case, there's money on the line, but benefits like reputation or personal satisfaction can also create powerful incentives. With a poll, the prediction is made without consulting anyone else. By looking at the current odds in a prediction market, traders are given another piece of information--they can examine their beliefs in the light of what others appear to believe. Each person sees the current "consensus" view and then makes a trade only if he thinks that view is wrong.
The skinny. In a world of accelerating technological change and global competition, anything that can help a CEO make a better forecast or smarter decision probably seems worth investigating. Pharmaceuticals giant Eli Lilly spends 20 cents of every sales dollar on research and development. That's up from 10 cents in the 1980s. And some two thirds of that money goes toward drugs that will never make it to market. So Lilly is experimenting with prediction markets to get a better handle on which drugs will be successful and which will win approval from the Food and Drug Administration.
Last year, Lilly ran an internal market experiment where instead of using the public as its pool of potential traders, the company tapped about 50 employees--chemists, biologists, salespeople--to trade contracts representing six hypothetical drugs. The object was to figure out which ones had the best chance of making it to the next phase of clinical trials. Participants used drug data from real compounds that the market's organizers would slowly leak out. As it happened, the three highest-trading drug candidates were, in real life, the three successful drugs, while the lowest-trading ones were trial failures. Asked if he was impressed by the outcomes, Alph Bingham, head of R&D at the company's entrepreneurial e.Lilly initiative, says, "Let me put it this way: We're not abandoning the experiments."
While Lilly is still figuring out how and where to apply internal prediction markets in the decision-making process, HP is already employing them for sales forecasts. Back in the mid-1990s, HP set up a series of experiments with California Institute of Technology economist Charles Plott to create a market around forecasts of future sales of its printers. A few dozen finance or sales people could buy or sell predictions about whether, say, August sales would be between 1,500 and 1,600 units. In six out of eight forecasts, the markets were significantly closer to the actual result than HP's official forecast. The company was so enthusiastic about the results--as well as those of some subsequent experiments--that one division is now using markets to predict monthly unit revenue. "The markets allow us to extract knowledge and put it to good use," says Bernardo Huberman, director of the Information Dynamics Lab at HP Laboratories.
Oddsmakers. Here's how the extraction process works at HP: The first week of every month, a group of managers is asked to place bets on a revenue forecast. HP takes the official revenue estimate and then comes up with 10 alternative possibilities, five higher and five lower than the official projection. Each possibility is represented by a bin on a computer screen. Managers then place 100 tickets into the bins, with the most tickets being placed in the revenue bins they think are most likely. The ratio of tickets to bins gives each manager's probability forecast, and then all those forecasts are aggregated. The manager who is closest gets a $75 check. "This is big," Huberman says. "Uncertainty is bad, and as we have shown, the knowledge that the members of an organization have can be used to predict certain future outcomes more accurately."
Even though some companies are dabbling with these markets internally, there might also be value in letting the public in on the action, as with the Iowa political markets. Direct-marketing firm Wunderman is trying to persuade its clients to set up prediction markets as a way of creating a useful online community around their products. "You love to have passionate customers like with Harley-Davidson or with iPod owners, and you want to be able to dialogue with them and access all the info that these communities generate," says Len Ellis, an executive vice president at the firm. A company could create a market not only about sales or earnings but also about whether new products or features will succeed.
A company that NewsFutures is working with is Japanese advertising behemoth Dentsu. Koichi Yamamoto, a senior manager there, thinks prediction markets will help improve forecasts of advertising demand and consumer trends. "The key value we see is that prediction markets have the potential to extract the best essence from group knowledge, as an alternative to majority decisions," Yamamoto says.
So might all this mean the end of corporate management as we know it in favor of a business world where prediction markets and not the suits will make the big calls? Bingham has his doubts. "We are not ready to get rid of our drug portfolio managers just yet," he says. Yet Malone thinks prediction markets will become a common tool for corporate America and symbolize a coming change in management style. "We are in the early stages of an increase in human freedom in business that may, in the long run, be as important a change for businesses as the change to democracy was for governments," he says. "Prediction markets are only part of this overall trend. It won't mean the end of management, but management will no longer be about command and control."
Presidential futures market
[Complete chart data are not available.]
Bush $0.499
Kerry $0.506
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0.46
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0.52
Source: Iowa Electronic Markets
This story appears in the August 30, 2004 print edition of U.S. News & World Report.