June 17, 2022

The current stock market sell-off has many investors asking themselves: Where will the bottom be?

At first glance, placing a bet on this might sound like gambling.

The line between gambling and investing can be fuzzy. In my view it depends more on the reasoning behind a bet than on the move itself. If you buy a meme stock because it’s popular on social media, that is gambling. If you buy the same stock because you researched that company’s potential, you have a thesis, and it fits into a broader strategy, that is different.

There are always new financial innovations, and a recent one has caught my attention: prediction markets. These markets allow participants to make bets on real world events, like the size of the Fed’s next interest rate hike.

At first glance, placing bets on events might sound like gambling. And for most people, it probably is gambling. But I see real potential for investors who learn how to use these markets effectively.

I can see a few ways that thoughtful investors might integrate prediction markets into a real investing strategy. First, these markets could offer new ways to hedge illiquid assets.

You could bet on events, like the passage of a piece of legislation, or other things with a relationship to the market. If an event happens that hurts your real estate portfolio, you get some money back from the prediction market bet.

In isolation, these bets would look like gambling, but as part of a larger portfolio strategy, this same behavior becomes investing.

I’m even more interested in using prediction markets for research. Markets integrate a lot of diverse information and, over time, they tend to be more right, more often, than individuals. As an investor, I could use prediction market prices to better understand the risks of various future events, without even needing to risk any capital.

Of course, betting in these markets is always risky, and buyers should beware. Markets with low trading volume or low liquidity will be vulnerable to manipulation, counterparty risks, and other problems.

Prediction markets are a really interesting innovation. They have the potential to be useful tools for sophisticated investors. I’m excited to see them evolve, and maybe even to add them to my toolkit.

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