ARE YOU INVESTING OR GAMBLING?

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

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

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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.

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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.

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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.

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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.

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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.

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

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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.

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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.

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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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