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From New Scientist magazine, vol 173 issue 2335, 23/03/2002, page 40

Ask the oracle

by Robert Matthews

Who's going to win an Oscar? Is there life on other planets? Nobody knows
for sure. But Robert Matthews knows how to make the best guess

RUSSELL Crowe will win an Academy Award for his portrayal of mathematician
John Nash in A Beautiful Mind. The film's director, Ron Howard, will win the
award for best director. Ian McKellen will take Best Supporting Actor. But
Judi Dench can forget it.

Says who? Says a new way of predicting the future with a stunningly
impressive track record. From film awards to presidential elections to
scientific and technological advances, it has picked winners with uncanny
reliability.

And where do these amazing insights come from? People like you. Those
predictions of this year's Oscars, for example, come from thousands of
ordinary punters who are interested enough in films to play a Web-based game
called the Hollywood Stock Exchange (HSX). Players who reckon they know
who'll win the Best Actor Oscar can buy shares in him using fake "Hollywood
dollars". The higher the demand, the more they'll have to fork out. But it
could be worth it: come Oscar day, players with a big investment in the
winner stand to gain vast amounts of-well, nothing much, apart from kudos.

Playing for fake money on pretend stock markets might sound like a sad
pastime for wannabe stock market traders (see "Playing the markets"). But
here's a thing: those imaginary stock prices have turned out to be eerily
accurate predictors of reality. Last year, HSX's army of amateur traders
correctly predicted the winners of six out of the eight main Oscar
categories. The year before they nailed all eight-better even than a poll of
the Academy members who actually decided the winners. This year, too, the
HSX traders seem to have lost none of their acumen: they correctly forecast
35 of the 40 Oscar nominees announced last month.

It's a success rate that has led to the game being taken very seriously by
movie moguls keen to gauge market reaction before they commit millions to a
film. "We get calls from agents and producers wanting their star, film title
or whatever listed on the exchange," says HSX vice-president Michael
O'Rorke. Some studios are even willing to pay HSX for detailed trading
information.

HSX's predictive power has also prompted people a long way from Tinseltown
to wonder exactly what's going on in these games. Are their forecasts really
as good as they seem? An international team of scientists is on the case.
What they are finding casts intriguing new light on some basic tenets of
economic theory. And it could have a huge impact on how businesses carry out
market research-and how we consumers decide what we'll buy.

Not bad for something that started out as just a teaching aid. For years,
economists have tried to find ways of convincing students that their
theories bear some resemblance to reality. For example, the "efficient
market hypothesis" says that share prices reflect the sum of all the
knowledge available to every trader-including the sneaky insider dealers.
That's because if they want to benefit from their information, they will do
so through trading which changes the share price and thus reveals the
implications of what they know to everyone else. Then a second basic tenet
of economic theory kicks in: "rational expectations", which says that
everyone in the market responds rationally to what they know, and buys or
sells accordingly. So stock markets allow communities of people to benefit
from each other's insights, with share prices giving a handy summary of what
that knowledge implies.

All very neat, but is it true? In 1988, economists at the University of Iowa
set up an artificial stock market to let students see the effect of some of
these key ideas for themselves. The market traded securities, contracts that
pay off only if an event takes place. This time they were tied to the
candidates in that year's presidential election.

Each security had to be paid for with real money. Once the election was over
the securities paid off according to the percentage of the final vote won by
each candidate. With real money at stake, students had a big incentive to
follow the intricacies of the presidential race. And, according to the
efficient market hypothesis, the final prices should have reflected the
total knowledge of all the players. How did they do? The market predicted
George Bush's margin of victory over Michael Dukakis more accurately than
any of the six national opinion polls.

Now, because of the Web, the Iowa market has opened its doors to anyone who
cares to take a punt on political and financial events such as the New York
mayoral elections or the financial performance of IBM. Renamed the Iowa
Electronic Market, it has consistently beaten the major opinion polls in
predicting the vote in presidential elections, including the dead heat in 2000.

The Iowa Market has spawned many imitators and trading is now possible on
artificial markets covering a stunning range of issues. Formula One Pick
Six, for example, trades in securities predicting the top six drivers in
Grand Prix races, while NewsFutures trades in current affairs securities,
such as the capture of Osama bin Laden by US forces. The Foresight Exchange
even trades in predictions of scientific breakthroughs, from the likely date
of a cure for AIDS to whether there will be a big quake on the US West Coast
before 2010.

These artificial markets are played for imaginary money and usually offer
little reward to successful traders apart from bragging rights. Yet they
have proved hugely popular: HSX has over 400,000 accounts.

It would be all too easy to dismiss what happens in these markets as just a
bit of fun, since with no real money at stake, no one's going to fret that
much over trading decisions. That should diminish their reliability. After
all, people can make rash trades without worrying about losing their shirts.

But it seems that economic theorists forgot that there's more to life than
money. Research by a team led by Dave Pennock of the NEC Research Institute
in Princeton, New Jersey, has revealed that people playing these toy markets
do indeed act as if they have something to lose: self-esteem and peer-group
approval. This triggers both market efficiency and rational expectations,
which combine to produce knowledge pooling-with a positive effect on the
games' predictive abilities. "People playing a market game are genuinely
interested and care about doing well," says Pennock.

To find out exactly what was going on, Pennock and colleagues took a closer
look at the movie market HSX. They found that its prices displayed a classic
attribute of a rational, efficient market, called coherency. As the price of
one Oscar nominee rose, those of at least one of the others dipped
accordingly, keeping the sum of all the prices more or less constant.

Price coherency doesn't just imply a market is operating efficiently and
rationally. It also means prices can be used as estimates of something else
that always adds up to the same figure: probability. In other words, the
market won't just tell you who will win, it will also tell you what their
chances are.

Analysing over 100 prices quoted on the HSX, Pennock and his colleagues
found that its price coherency was not quite as good as a real-money market.
Its predictions remain pretty accurate, though. If Sissy Spacek's shares are
worth 40 per cent more than those of Judi Dench, then Spacek has a roughly
40 per cent bigger chance of taking the Best Actress Oscar.

Pennock's team has uncovered price coherency in other artificial markets,
including the Foresight Exchange, which deals in securities on all manner of
future events ranging from Arnold Schwarzenegger becoming president to
whether the Higgs particle will be found by 2005. Again the prices could be
turned into probabilities. For example, a bunch of securities consistently
trading at FX$0.80-80 per cent of the maximum price-came true around 80 per
cent of the time. Similarly, claims with low prices, such as "O. J. Simpson
vindicated by 2000", duly turned out to be true only very occasionally.

Not everyone's impressed. Bob Worcester, chairman of London-based opinion
survey company MORI and doyen of pollsters, dismisses artificial markets as
just the latest in a long, sorry list of claims to have found a way of
beating opinion polls: "We must get half a dozen offers to go into business
with these each week, and we always show them the door."

Worcester's big problem with artificial markets is their lack of a
mathematical basis. He points out that opinion polls are underpinned by
tried-and-tested statistical theory, which demands them to be as large,
random and unbiased as possible. The theory also allows estimates of the
likely error: around plus or minus 3 per cent for the standard 1000-person
poll. There's no guarantee that an artificial market will be as rigorous,
since the traders are usually self-selected and their numbers can be very
small. Without this assurance, the results are beset by suspicions of bias
and outright manipulation.

Yet opinion polls hardly have a glowing track record. The polls for the 1992
general election in Britain notoriously failed to get within 8 per cent of
the actual result, chiefly because voters refused to give their views. But
according to Worcester, alternatives such as artificial markets are even
worse. "They're voodoo polls," he says.

Pennock himself accepts that there are some key issues to be resolved-not
the least being how many active traders the markets need to produce accurate
predictions. "I'd guess something on the order of 20 to 30 people could be
enough," he says. "But the Web can draw from a global audience, so even
esoteric topics could have enough to drive forecasts."

See the future

But one person at least is ready to bet the farm on the power of artificial
markets. Later this year, Canada-based entrepreneur Leonard Brody plans to
launch Ipreo, the first company offering artificial market services to those
who want to see the future.

According to Brody, businesses all over the world spend billions of pounds a
year trying to second-guess the response of real markets to uncertain future
events. He thinks he can grab a big chunk of this from market researchers
and focus groups by offering them an alternative with a proven track record.
His artificial market would act as a financial test bed where real-life
players trade according to how they see a company succeeding in the
prevailing market conditions.

For example, private companies could track the performance of imaginary
shares before dipping their toes in a real stock market. It could also help
investors estimate a sensible valuation for a new company offering products
or services never seen before on real markets. "The Web allows us to tap
into collective knowledge as never before," says Brody. "Artificial markets
capture this in a single metric-price-instead of the complex responses you
get from market research."

Ipreo will initially draw its traders from business schools, offering them
prizes as incentives for taking part. Brody recognises the dangers of market
manipulation, and says that a raft of safeguards such as Internet
address-checking will be put in place. "We know who all our traders are,
unlike stock markets like NASDAQ."

But it is not just companies that stand to benefit from this new source of
insight, says Pennock. Artificial markets could also transform consumers'
decisions about what they buy. "Imagine if you knew that VHS would win the
video wars," he says. "You'd never have let the salesman talk you into
buying that Betamax machine."

You can't hear about trading on artificial markets without possible
candidates springing to mind: the success of 3G mobile phones, for example,
or the chances of nuclear fusion power before 2030. Oddly, no one seems to
have set up the most obvious artificial market of all: shares in the success
of artificial markets. No doubt it's only a matter of time, and on the
evidence to date, they're a definite "buy".



Playing the markets

Anyone can become a trader on the artificial markets: it's just a matter of
registering, grabbing some fictional money to play with, and using it to
trade with on the market.

Open a Hollywood Stock Exchange account, for example, and you'll be given
two million "Hollywood dollars" (H$) to spend and a range of ways of doing
it. One of the most popular is to bet on the Oscars. As soon as the nominees
are announced, HSX issues stock for each nominee, priced at H$5, and the
buying and selling starts. As traders feed in their insights-from how the
nominees perform in the Golden Globes, for example-the prices diverge, with
the favourites becoming the most expensive. Hot-favourite director Ron
Howard, for example, is currently trading at H$13.75, while outsider David
Lynch is just H$1.75. On Oscar day, each security you hold in a winner pays
you H$25; everything else is worthless.

But striking it rich isn't just about buying winning securities. You can
also make a killing on trades. For example, you might buy up a cheap stock,
hoping for a last-minute surge in popularity. Then you can sell, sell, sell
and make a tidy profit.

Other markets operate in broadly similar ways. The Foresight Exchange, for
example, lets you wager fictional "FX bucks" on claims that may or may not
come true by a specific date-such as "Japan has nuclear missiles by 2020".
To buy stock, players issue a "bid" price. If this matches a seller's "ask"
price, they make a trade (For a selection of claims and their current
prices, see bottom of pages).

If a claim comes true, each security you hold pays out FX$1. But it's not
necessary, or even advisable, to wait that long. Simply buy and sell
cleverly as perceptions change over time. For example, securities in the
claim "Evidence of extraterrestrial life will be discovered by 2050" debuted
in 1995 at FX$0.30. By late 1996 you could sell them for FX$0.80. The
difference? In October of that year, NASA announced it had found traces of
fossil bacteria in a Martian meteorite.

Further reading:   Play the Hollywood Stock Exchange at www.hsx.com, or the
Foresight Exchange at www.ideosphere.com

Robert Matthews is science correspondent for The Sunday Telegraph
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