I've noticed something very curious on Intrade markets for 2012 Republican Presidential Nominee - Ron Paul gets 3.5% of getting a nomination - a value that's clearly (and spare me EMH here) wishful thinking of Ron Paul supporters more than any genuine estimate.
And this brings me to a question - if prediction markets overestimate chance of winning of some rare case, how can I profit from that? Naively if I know true chance is 1%, I win $3.5 99% of the time, and lose $97.5 1% of the time, for expected payoff of $2.5. But my maximum loss is 39x higher than my expected profit, and I won't be getting any money out of it for three more years.
I'd need to bet significant amount to earn any money out of it, and that would require accepting 39x as high maximum loss. No reasonably prediction market would accept this kind of leverage without some collateral, nor could I get any reasonable loan for it at rates that would make this arbitrage profitable.
The only way I can think of would be convincing someone with plenty of money that I'm right, and have him provide me with collateral for some (probably very high) portion of the payoff. But if results depend on my ability to convince rich people, that's not prediction market! None of this is a problem for people trying to artificially pump estimates for Ron Paul - they'll just take the loss, and write it off as marketing expense.
None of these problems occur if some position is vastly overestimated, like 60% estimate if I know true value to be 40% - this would be a cheap bet - maximum loss of $40 for expected profit of $20, and people who want to pump it need to take about as much risk as people who want to bring it back to the true value, not a lot more.
I'm confused. Is there some nice way to arbitrage this, or is this an inherent weakness of prediction markets and we should only trust positions they pick as leaders, not chances of their long tail?
Given your first paragraph, I think your question answers itself: his evidence is the 3.5% figure, which (for reasons unspecified) he considers an obvious overestimate.
There is something rather odd going on in this discussion, whose structure is as follows. A indicates belief in proposition p; B notices that p => q; B challenges A to supply evidence for q. This seems to presuppose that A's belief in p is actually derived from a prior belief in q, since otherwise p would be the proposition to ask for evidence of; but when asked, B claims that s/he is only saying "A believes p, p => q, so A must believe q". Which, by the by, is invalid if there's any doubt about A's agreeing that p => q. And, in this instance, there is plenty of scope for doubt about p => q: perhaps, for instance, Ron Paul supporters in general are no more prone to wishful thinking than anyone else, and no more prone to participate in Intrade, but there are one or two extremely determined and well-heeled ones.
The way I read his post it didn't seem to me that he believed that the Intrade odds were an obvious overestimate for reasons unspecified. Rather it seemed that he proposed two possible reasons for the odds being overestimated. One was that the wishful thinking of Ron Paul supporters explained the overestimate, the other was that Ron Paul supporters were deliberately bidding up the market as a marketing exercise.
The weakness of the second explanation has already been pointed out. The first explanation is only an explanation at all if Ron Paul supporters ar... (read more)