ROI-Prediction markets are gambling and that’s a good thing: Marty Fridson

In fact, traditional investing would be worse off without them. THE POLLING PROBLEM While prediction markets may price the likelihood of some activities of little importance to investors– such as who will win the Academy Award for ‌Best Actor – they can also provide very useful information for investors, particularly about political events.

The debate over calls to regulate prediction markets cuts to ​the heart of how we differentiate among gambling, speculation, and investment, raising the question of why the prejudice against making ​market “bets” persists. Operators of prediction-market sites - platforms where users buy and sell contracts tied to the ‌outcome ​of future events, from elections to policy appointments to economic indicators - are keen to disavow any connection between their offerings and gambling. But does that claim hold up? Consider the famous argument between biologist Paul Ehrlich and economist Julian Simon. Ehrlich, author of The Population Bomb, maintained that global population growth would cause catastrophic shortages of essential resources. In 1980, he staked $1,000 on the proposition that over the next decade ‌the prices of five commodities - copper, chromium, nickel, tin, and tungsten - would rise in inflation-adjusted terms. Simon risked $1,000 on his contrary contention, which ultimately proved correct. Nowadays one could enter into a similar sort of contract through a prediction-market provider such as Kalshi. Ehrlich and Simon, however, explicitly called their exercise a bet - not a "contract" or some other ambiguous term. In fact, Ehrlich used the word “gambler” in reference to their agreement.

The distinction between gambling and what prediction markets offer thus appears to be one of semantics, not of form. However, this does not mean that prediction markets – and other ‌forms of short-term speculation – are inherently harmful. In fact, traditional investing would be worse off without them.

THE POLLING PROBLEM While prediction markets may price the likelihood of some activities of little importance to investors– such as who will win the Academy Award for ‌Best Actor – they can also provide very useful information for investors, particularly about political events. Active investors often premise buy-and-sell decisions on expected outcomes of elections. While public opinion polls are a source of information about likely voting results, they have produced some noteworthy failures in recent years.

Research consistently bears out prediction markets' edge. A landmark 2008 study found the Iowa Electronic Markets outperformed polls 74% of the time across five U.S. presidential elections. A more recent Vanderbilt University study found that Polymarket - with $3.7 billion wagered on the 2024 race - beat traditional polls in predicting the outcome, especially in swing states, because bettors stake money on who they think will win, not merely who they want to ⁠win.

This is not ​to say that prediction markets are infallible. Until shortly before the 2016 Brexit ⁠referendum, prediction markets indicated with probabilities as high as 85% to 90% that British voters would opt to remain in the European Union. When the votes were counted, however, the result was 52% in favor of Brexit. The reasons for this massive miss have been widely debated, with analysts pointing to market manipulation, participants misreading available information, ⁠and - perhaps most tellingly - systematic bias among bettors themselves.

The same dynamic likely explains why prediction markets heavily favored Hillary Clinton, only to be confounded by Donald Trump's victory in the 2016 U.S. presidential election. Nonetheless, it is beyond doubt that prediction markets have become a tool investors increasingly rely on when assessing the market’s ​take on political events – and that itself can make them impactful.

IN PRAISE OF SHORT-TERMISM The debate about gambling versus investment often features another common market misconception: the idea that speculation of any kind is detrimental to markets precisely because it is short-term. ⁠According to this line of thinking, only long-term investors truly add value. The reality is quite another matter. Short-term trading enables securities prices to adjust quickly to new information. If long-term buy-and-hold types were the only market participants, price discovery would be severely constrained. Rapidly changing risks and prospective returns would not be reflected in prices. Misallocation of capital would ⁠result, causing ​the economy to perform below its potential.

Oh, you may say, but that applies only to transactions premised on such things as companies’ fluctuating fundamental outlooks or releases of macroeconomic indicators. Surely, no social value is created by high-frequency trading (HFT) that focuses on order flow, momentum, and minor intermarket price disparities? In fact, the trading volume generated by HFT enhances market liquidity. Even market participants with somewhat longer investment horizons value the ability to establish or exit a position quickly, with minimal cost in terms of bid-ask spreads. That liquidity arguably boosts capital investment ⁠and, in turn, economic growth.

A long-term focus remains wise for investors saving for retirement or a child's education. But they would find it harder to reach those goals without the participation of traders pursuing entirely different objectives. Gambling via prediction markets – and speculation more generally – may ⁠sound unsavory, but markets would struggle to function well without them.

(The views expressed ⁠here are those of Marty Fridson, the publisher of Income Securities Investor. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors, and Special Assistant to the Director for Deferred Compensation, Office of Management and Budget, The City of New York.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn, ‌and X. And listen to the Morning Bid daily ‌podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets and finance seven days ​a week. (Writing by Marty Fridson; Editing by Anna Szymanski and Marguerita Choy)