HOME
POSTS

# 006 The Wisdom of rationals

For years now I have been fascinated by prediction markets. The source of excitement is the idea is that you can use financial markets to do inference — just like machine learning.

## The assumptions of prediction markets

Prediction markets operate upon 3 main assumptions. The first assumption is that markets are made up exclusively of 3 types agents. A classification of these agents is as follows.

1. The pure gambler, this one doesn’t have the necessary meteorological information. He/She is simply betting at random.
2. The accurate information trader, these traders have information they think points to the fact that it will rain & they are right.
3. Inaccurate information traders, have information they think points to the fact that it will rain. But they are wrong.

The second assumption, is that The Information is predictable, this means that amongst all the market participants, at least agent is an Accurate information trader.

The last assumption is that people in these market agents will perform a Rational participation. Rational participation means that, speculators will always prefer to place bets on event outcomes which they think they will make money & they will decline from participating in bets where they think they will lose money. For instance, a rational person should not be a pure gambler because they have higher chances of making money by betting on information they know at least something about.

The accurate information trader on the other hand will flourish in this market as they will always have the edge in the market & thus make money off clueless gamblers & people signaling wrong information. Meanwhile, agents that always bet on wrong information will go bust or switch to markets where they do better. This is what makes prediction makers so resistant to market manipulation, it’s a system where agents signaling wrong information actively subsidizes people signaling correct information.

In theory, markets that repeat themselves should improve with every iteration (since most agents that signal wrong information are bust). Provided all agents have access to finite amounts of money.

## How to break a prediction market

Prediction markets may be highly resistant to manipulation, but that does not mean they cannot break. For a market to continue doing correct inference (accurate predictions), the sum of money held by the
class of Accurate Information traders should always be greater than the sum of money collectively owned by the rest of the agents. This is because all agents have finite amounts of money. And it will not be possible to offset noise incorporated into the market by agents with bad information. This may however improve in subsequent iterations of the market (agents signaling wrong information go bust) thus giving prediction markets a self healing like property.

It is often mentioned that prediction markets are based on “The wisdom of the crowds” & that creates a false analogy where people this it works for the same reason democracy does, but they are actually based on the wisdom of the rationals, a system where people don’t talk about what they don’t know.