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Before fees, prediction markets are a zero-sum game. So who are they actually for?Erin Hooley/The Associated Press
Charles Martineau is an associate professor of finance at the University of Toronto, and Marius Zoican is the Canada Research Chair in financial technology and associate professor of finance at the University of Calgary.
Prediction markets are, on the face of it, exceptionally straightforward: You can buy contracts that pay $1 if an event happens and nothing if it does not. Some of these contracts allow you to bet on the economy: “Will the Bank of Canada cut rates by 25 basis points at the next announcement?” or “Will the S&P surpass 8,000 this year?” Yet others may focus on sport, politics or entertainment. One can bet on whether Katy Perry and Justin Trudeau will be engaged by the end of the year.
The simplicity of the payoffs and contract language accounts for the rising popularity of prediction markets. In Canada, Wealthsimple recently launched Predict, becoming the second Canadian dealer, after Interactive Brokers, to offer prediction market contracts to investors. However, Canadian regulators restrict the brokers to only economy- and climate-based contracts – which resemble financial derivatives – and leave out “sexier” contracts on miscellaneous topics. We argue that this is the correct approach and urge the regulators to stay the course.
Canadian securities regulators decline to oversee sports, entertainment contracts for prediction markets
There is a fundamental difference between investing and trading, and prediction markets encourage too much of the latter while diverting attention away from the former. Young people in particular are attracted to contracts on real-world events put down in simple worlds promising a quick profit. They get the same dopamine rush from prediction markets as they would from sports gambling. In a worrying trend, financial advisory company Betterment found that 26 per cent of Gen Z investors include sports betting in their financial strategy. Legitimizing sports betting by presenting it as a viable strategy on an investment brokerage app will make this problem worse.
The catch is that is very difficult to make money on these platforms. Recent studies show that prediction markets are, on average at least, efficient: Contract prices are a good reflection of the probability the event comes to happen. The flipside is that, if prices already reflect information, you cannot expect to make a profit from your bet. Once spreads and fees are taken into account, you can in fact expect to lose money. A study concluded that the top 1 per cent of accounts with positive returns on prediction market platform Polymarket capture about 77 per cent of all profits.
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So, let’s say it plainly: Prediction markets are not for you. Not for 99 per cent of you. Before fees, they are a zero-sum game: For every winner, there is a loser. After fees are accounted for, the average investor makes a loss.
Further, we emphasize two subtle dangers that go beyond your short-term bottom line. First, some investors might develop a gambling addiction. Second, every dollar you put into a prediction market instead of a low-fee index fund is a dollar that stops compounding.
Financial advisers and finance professors have spent a generation trying to convince young investors that building wealth means putting $50 or $100 a month into a diversified ETF that mimics the aggregate market returns and letting it ride for many years, capturing the market’s long-run average annual return of 7 to 8 per cent. Redirect that same $100 into prediction market event contracts, and you have quietly given up building long-term wealth through compounding and minimizing transaction costs.
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So, who are prediction markets for? Possibly, those that need to hedge risk. For example, an ice cream shop owner who buys a contract that pays out if the summer turns out unusually cold, offsetting a real business risk. Hedging this sort of risk is not easy for small businesses and this is where prediction markets can be useful. The second is the sophisticated trader: Someone with the modelling skill to spot heavily mispriced contracts (e.g., a contract currently priced at 30 cents when it’s worth closer to 45 according to your model), and the discipline to repeat that process profitably.
Some would argue that Canadians deserve the freedom to access legal financial products that carry real risk, the same way they can buy penny stocks or options. This is a legitimate view, but the risks should be spelled out clearly: Governments and school boards need to take financial literacy seriously starting in high school, before a generation raised on social media “investment” tips and parlay culture grows up mistaking prediction markets for a retirement plan.