06.10.06
Prediction Markets
I was at the prediction market summit in Chicago this Wednesday, and I got to hear some of the people who are at the cutting edge of research in prediction markets. A prediction market is a market that is used to aggregate the information of all its participants, and to estimate or predict things more accurately than any individual or group in that market. The hollywood stock exchange is a perfect example of a prediction market. In this market people buy and sell stocks on movies which are valued based on the total revenue that a movie produces during its opening weekend, so after the movie opens the stock holders in that particular movie cash out. So while trading in a movie, the market participants are guessing what they think that movie will gross. It turns out that the hollywood stock exchange is a very accurate predictor of the revenue a movie will bring in. The same is true with other prediction markets on sports, election results, news buzz, etc.
We all know that markets produce efficiency by leveraging the self interest of those participating in them. We learned in economics 101 that everybody trading in a market ends up the same or better off after the trade, and that is why capitalist countries are rich to the extent that their markets are free, and why socialist countries are poor to the extent that their economies are planned (for an experiment confirming this, look up East vs. West Germany in your history books). One thing we might not learn in economics 101 is that markets are also the most efficient ways to discover, aggregate, and propagate information that is hidden in the mind of its participants, and that is the point that research in prediction markets tries to emphasize. With millions of people buying and selling, a market somehow figures out the exact price at which supply equals demand, so a standard market can be thought of as a prediciton market for the equilibrium price. Thus, prediction markets harness this property of markets to learn other things that may have nothing to do with prices. They are excellent tools to exploit the collective intellect of an organization, for example to forecast the sales of a company by creating an internal market for all its employees.
In a previous post (Let the invisible hand grab your long tail) I was saying that a business that wants to serve the long tail of its market would be well served by leveraging the power of markets. My example of a long tail business that leverages the invisible hand of a market was eBay. I argued that since markets provide incentives for participants in a long tail business to serve each other's needs, it made it cheap for the business to serve its customers. It turns out that prediciton markets are yet another way in which the invisible hand should be allowed to touch your long tail.
12.20.05
If you liked Crossing the Chasm….
If you liked the book Crossing the Chasm by Geoffrey Moore, I have great news! Geoffrey Moore has a blog, and he has a new book coming up, Dealing with Darwin.
I have been a big fan of Geoffrey Moore throughout my career in the software industry. During my undergraduate at Caltech several entrepreneurs I met told me that if I wanted to start a company I had to learn about marketing, and if I wanted to learn about marketing, I had to read Crossing the Chasm. I took their advice, and I became an instant fan. I went on to read Inside the Tornado, and The Gorilla Game.
Crossing the Chasm is all about what to do when you have a great technology and you want to build a company out of it. In a nutshell, products follow an s-curve in their adoption cycle, and the people who adopt them can be grouped into the following categories: Technology enthusiasts, visionaries, early adopters, late adopters, and laggards. Each of these groups has its own set of values, and each of them must be approached very differently from a marketing perspective. These groups tend to distrust each other, and members of one groups don’t make great references for the next group. The problem, which Moore calls the chasm, comes when you need to go from the visionaries to the early adopters. The early adopters and the late adopters will give you all your money, but in order to get to the early adopters you need to jump from the visionaries to the early adopters, and that is where Geoffrey Moore sees the chasm. Visionaries don’t need much references because they want to be the first doing something, and late adopters have the large early adopter market as a reference, so jumping from technology enthusiasts to visionaries and from early adopters to late adopters is not that difficult. In stark contrast, early adopters deeply mistrust visionaries, and they require referenceable accounts in order to buy, but a visionary account is not referenceable for them. What to do? Read Crossing the Chasm to find out!
Inside the Tornado is about what to do once you have crossed the chasm and you are in what Geoffrey Moore calls “the tornado”. Your company has gone through “the bowling alley” when it used the revenues, credibility, and experience it gained in conquering the early adopters of one niche to attack and conquer other niches, taking them down as pins. At a certain point, your portfolio of niches unifies into a platform, you have proven you can dominate that market, and everybody wants yor products. This is when you go into a hypergrowth phase, your company enters a “tornado” where your demand is much larger than your production capability. Inside the Tornado shows you how to compete and win in this situation. You can become the 800 pound gorilla in your industry, and Geoffrey Moore shows you how. If you didn’t get to be a gorilla during a tornado, Moore also talks about competitive strategies for companies holding the second and third places, as well as the rest of the followers. Moore calls these other companies the chimps and the monkeys.
The Gorilla Game looks at companies from the point of view of an investor. If there are principles that you can use toward creating a successful company in the technology marketspace, then there are principles that you can use identifying these companies. How do you identify an industry that is ready for a tornado? How should you place your bets to ensure that you make money in a tornado market? The Gorilla Game tells you all that.
Now Geoffrey Moore seems to be focusing on what to do after you are a gorilla, how to use innovation for competitive advantage. This is what I think Dealing With Darwin will be about. In his blog he talks about his new model for innovation, which has four main directions in which you should focus depending the age of your company and your industry: Product leadership, marketing leadership, mature market leadership, and renewal innovation. Under each of these directions there are several types of innovation that you could try to target: Disruptive innovation, as well as application, product, and platform innovations all fall under product leadership. This type of innovation is what Crossing the Chasm was all about. Line extension, enhancement, marketing, and experiential innovation all fall under marketing leadership. He dealt with this extensively in Inside the Tornado. Value engineering, process, integration, and business model innovation fall under mature market leadership. I think this will be part of Dealing With Darwin. Renewal innovation includes organic renewal, structural renewal, and harvest and exit. This should also be part of Dealing With Darwin.
10.06.05
Let the Invisible Hand grab your Long Tail
There has been a lot of buzz recently about leveraging The Long Tail as the new way to do business. The idea in a nutshell is to turn the Pareto rule of 80/20 on its head. Traditional business wisdom states that since 20% of whatever you sell will give you 80% of the revenue, you should focus all your effort on the most profitable 20% and ignore the other 80%. This is a good idea when it costs you money to carry an inventory and you serve a limited geography, but when that does not apply as it is the case with many web-based businesses, it pays to serve the traditionally ignored 80%. This typically ignored 80% is what Chris Anderson called the Long Tail.
Netflix is a good example of a company leveraging the Long Tail. I am a big fan of a show called Babylon 5 which aired in the mid 90s, but was moved from public TV to cable because not enough people were interested on it. I was not in the mainstream who didn’t care for the show, I was in the Long Tail of the relatively small fan base. I figured I would rent it later when it came out on video, but since it was an unpopular show to begin with, movie rental places didn’t carry it. Finally, thanks to Netflix, I watched all the episodes from beginning to end last year on my own schedule and without commercials. By paying attention to the areas where I fall on the Long Tail, Netflix has made me a loyal customer, and it has taken my business away from Blockbuster, not only on the Long Tail products, but on the mainstream products as well.
In contrast to the Long Tail which is a relatively new idea, the concept of The Invisible Hand has been around since 1776, when Adam Smith wrote The Wealth of Nations. In this masterpiece, Adam Smith argued that when individuals are left alone to act in their own self interest, the aggregate effect of all their actions raises the welfare of society as a whole as if it was directed by an Invisible Hand. Ever since then, the concept has been used to refer to the inherent power that free markets have as a way to create spontaneous order and prosperity. In modern Economics, the Invisible Hand is an euphemism for the market equilibrium and efficiency that is achieved globally when rational (i. e. self interested) individuals are free to maximize their utility locally.
So what does the Long Tail have to do with the Invisible Hand? I believe that in the long run, the most prosperous business models will be those that harness the power of markets (the Invisible Hand) in order to serve their Long Tail customers. The quintessential example of that business model is eBay. eBay leveraged the Invisible Hand by creating a market where self-interested individuals can buy and sell things. eBay doesn’t have to spend large sums of money marketing the products it sells, or scouting the market to buy products at a low price. Instead, buyers and sellers do all the work for them, and all eBay has to do is take a cut of every transaction. People go to eBay because they want to buy or sell things that are too odd for normal retailers to carry. Standard retailers serve the 20% of customers that want to buy typical things, eBay serves the 80% of the customers in the Long Tail that want to buy strange, one-of-a-kind things. However, once people start using eBay they get hooked and start buying and selling things that they would have bought or sold in a more traditional store.
Another business that takes the Invisible Hand to the Long Tail is online matchmaking. This is not a monetary market, but it is still a market where self-interested individuals try to “buy” and “sell” their products. Each one of them wants to get matched to the best person they can “afford”, so they do all the work, and the matchmaking site takes a piece of the action. The traditional matchmaking market, the singles bar, caters to the 20%. In contrast, online matchmaking allows “non-standard” people to find each other based on things that are not apparent in a singles bar, such as personality, books read, political ideas, career goals, and even fetish preferences. The first customers of online matchmaking sites were considered “losers” in the traditional market. However, by leveraging the Long Tail of the matchmaking market, online sites were able to attract more “normal” customers, and today their typical customer is very similar to the typical customer of the singles bar.
Why do I think that leveraging the Invisible Hand is important? Because the Long Tail of the market is a lot more difficult to serve than the 20%. Their demands are unique, and even without carrying a physical inventory, trying to satisfy unique demands takes effort, which translates into costs. eBay would have to have a very large warehouse in order to serve their customers without the use of a market, which would be very expensive. Matchmaker sites would have to have their own city in Nevada to serve their customers without the use of market forces, and their service would be a lot more expensive.
If you want to take business away from established competitors who ignore the Long Tail, you need to service the Long Tail, but doing so is going to cost you, and you can mitigate these costs by creating a market. In a market the service provider for one of your customers is another customer, not you. The key to getting customers to serve each other’s needs, is to create an environment where both sides of each transaction are serving their own self-interest. It is in the self interest of buyers in eBay to give their money in exchange for the unique products they seek, and it is in the self-interest of sellers to promote their products in order to get money for them. In the matchmaking market, it is in the self-interest of each side of the match to provide as much information as possible in order to “close the deal” and get matched to another person.
Another reason why it is important to create a market is network economics. Markets are natural monopolies, a market is more valuable as more people use it, so a company that can build a market creates a competitive advantage that gets stronger every day and provides a barrier to entry for competitors. Every new eBay user makes it more valuable for all other eBay users to be there. A matchmaking site is more valuable when it has more customers because it has more potential matches. The beauty of this model is that the larger the market gets, the more you can charge the users of that market, and they will pay because they find value from being in that market.
But the main reason why you need to use the Invisible Hand in order to serve the Long Tail, is that you cannot possibly do it by yourself as well as the free market. Trying to serve the Long Tail without the local knowledge of each individual is like trying to control an economy via central planning. The communist experiment showed that it does not work. Successful governments serve the Long Tail of their populations by creating the conditions for a free market, and they get paid handsomely by taxing the participants on that market. If you use the Invisible Hand to grab your Long Tail, you will be able to do the same.
03.17.05
Can we predict the market?
According to some economists, it is futile to try to predict what the stock market is going to do because markets are too efficient for any prediction to work. The argument goes like this: Markets are efficient. –> All information, facts, rumors, and expectations about a particular stock, an industry, and about the market in general, are already accounted for in the price. –> Any change in information is instantaneously reflected in the stock price. –> Any change in information has equal probability of affecting the stock positively or negatively, if this weren’t the case, arbitrageurs could make money buying the stock if the probability was biased toward the positive, or shorting the stock if the probability was biased toward the negative, and their actions would make the stock move into a probability neutral position. –> Stock prices should only be modeled as a Markovian Random Walk, as Brownian Motion, or any other model that is purely random. –> Since one cannot predict randomness, trying to predict the market is as foolish as trying to predict the sequence of heads/tails produced by repeatedly flipping an unbiased coin.
On its face, the argument sounds convincing (I confess that my training in economics had me convinced of it for a long time), but there is a big problem with the argument. If markets are so efficient, the information that they are efficient should be embedded in them. In particular, markets should account for the fact that it is futile to try to predict them, and the value of trying to predict the market should be zero, or negative, because money would be wasted unnecessarily in a futile endeavors.
However, the fact is that Wall Street analysts, traders, and fund managers are very well compensated for their attempts at market prediction. This fact flies on the face of the argument above, whether markets are efficient or not. If markets are efficient, then the knowledge embedded on them seems to indicate that they in fact can be predicted. Therefore, we should trust that information and conclude that in fact they are predictable. If the above argument is right and markets cannot be predicted, the fact that those who make a living predicting them get compensated so well is a persistent market inefficiency. The observation of a market inefficiency shows that markets are not necessarily efficient. This calls into question the efficient market assumption on which the unpredictability argument rests, therefore, it calls into question the whole argument. If the argument is wrong, then we have no reason to believe that markets are inherently unpredictable. Thus, whether markets are efficient or inefficient, the argument against predictability is wrong.
One would expect that if markets were predictable we would have a good model by now on how the market works, given that it is a question that so many people want to answer. However, I think that the words of a former professor of mine describe best why we don’t have any models of the market. I remember he said to me, “This is the reason why I don’t trust published research on market prediction. If I tried to predict the market and failed, I would publish a paper. If I got some results that showed promise, I would turn it into a product and sell it. If I got good results, I would sell my services as an advisor or money manager, but I would not tell people how I do it. However, if I got really good results, I would not tell anybody and I would invest my own money”. So there might be people out there that already figured out how to predict the market, they are just not telling anybody.
