ELLEVEST INSIGHTS

Despite the ongoing conflict with Iran, a 50% surge in oil prices year to date, and inflation reaching levels not seen since 2023, the US stock market hit record highs this May with the S&P 500 climbing 5% and the Nasdaq up 7%. International equity markets posted similarly strong results, developed markets returned 4% while emerging markets posted a 9% return. The most recent earnings season demonstrated that corporate profits continue to reach record levels despite macro and geopolitical headwinds.

In contrast, bond markets appear to be more cautious and are about flat year to date. Yields have continued to climb as investors brace for a “higher for longer” interest rate environment. Despite Kevin Warsh, a known advocate for lower rates, taking the lead at the Federal Reserve in May, the market is now pricing in a potential rate hike this year to continue the fight against inflation. 

The SpaceX IPO, with an estimated valuation of $1.8 trillion, is the next highly anticipated IPO after Cerebras’ impressive opening in May. OpenAI and Anthropic are also expected to go public this year. Some may think of this market behavior as complacent, but it suggests a broader shift toward higher risk tolerance among both institutional and retail investors. So it’s really no surprise that this level of euphoria has fueled a growing area in financial markets … prediction markets.

Betting on the Future

Imagine your best friend is opening a restaurant and wants you to invest in it. You could become an equity partner for potential growth or opt for something safer, like lending her money through a loan.

To make this decision, it would be prudent to do some homework. Is her business plan reasonable and scalable? Does she have experience in the food industry, or is she just really good at watching The Bear? Can you afford a risky equity position or should you diversify with a loan instead?

But what if there is another option … you could simply make a bet with your other best friend on whether the restaurant succeeds or not. For example, you could agree that if sales hit a specific target, you double your money. If they don’t, you lose everything. Forget about reading business plans and dealing with legal paperwork. 

The first scenario is traditional investing. The second is similar to good old-fashioned gambling. But today, prediction markets is the new sophisticated term for it.

What Are Prediction Markets

Prediction markets are platforms that allow the public to forecast and hedge based on their perception of future events. Bets are made via “event contracts,” which function as binary options with “yes” or “no” outcomes.

The value of these contracts is tied to an underlying event like, for example, “Will total rainfall exceed two inches in Los Angeles in May?” Contracts are priced between $0.00 and $1.00. A contract with a 60% probability of occurring would cost $0.60. If rainfall exceeds two inches in May, it pays out $1.00. If it doesn’t, the value drops to zero and you lose your $0.60. It’s a simple design that aggregates thousands of individual opinions and has created real-time and surprisingly accurate weather forecasts.

The Pandemic and the New Retail Investor

The COVID-19 pandemic altered market dynamics and human psychology in ways that are still being studied. Lockdowns, stimulus checks and zero-fee apps encouraged younger retail investors to engage with the market in unprecedented and more risk-taking ways.

The GameStop (GME) mania led by Reddit's RoaringKitty (Keith Gill) was a turning point. While a lucky few cashed in on millions (himself included), big Wall Street firms suffered historic losses. This era triggered a cultural shift. From meme stocks and Dogecoin to astronomical gains (and losses) in NFTs, retail investors became very comfortable with risk and abstract assets. People didn’t just want to buy predictable dividends and solid earnings. Platforms quickly realized there was a huge appetite to monetize users’ worldview. 

The Big Players and Regulation

Currently, two giants dominate the field. Kalshi was founded in 2018 when its founders realized that while the financial industry had complex markets and derivatives to predict future macro events, regular people had no straightforward way to trade directly on event outcomes. Polymarket’s founder, Shayne Coplan, took a different approach and built the platform on the Ethereum blockchain to make it globally accesible.

Their meteoric rise in these platforms’ valuations ($22 and $15 billion respectively), seems to be supported by fundamentals. Both platforms make money by charging transaction fees on each trade. Not surprisingly, they are marketing aggressively. Kalshi has turned to TikTok and even controversial AI-generated ads featuring Jesus and the Wright brothers. The company is also trying to attract women by diversifying contracts beyond sports and utilizing young female influencers on social media platforms. Their strategies seem to be working. Combined monthly global volume on these platforms has exploded from less than $5 billion to roughly $24 billion in less than a year and women currently represent about 26% of users, doubling from just a year prior.

Sports event contracts make up the majority of volume on prediction markets and their interface closely resembles sports gambling. Naturally, this has triggered a constitutional showdown over who actually has the right to regulate them. Kalshi argues that as a financial exchange, their regulation falls under the jurisdiction of the CFTC. However, seventeen states are challenging the legality of these companies. Minnesota banned them outright and almost immediately, the CFTC filed a lawsuit against the ban. The federal government is actively suing states to protect your ability to bet on who will be a bridesmaid at Taylor Swift’s wedding (spoiler: Selena Gomez is leading the charts).

To add to the complexities of regulation, insider trading is also being investigated. Back in April, a US soldier was arrested for making a series of wagers on Polymarket using classified information concerning a military operation to capture then Venezuela’s president, Nicolas Maduro. He made $400,000 on this bet. This is not an isolated incident. Polymarket accounts placed more than 80 winning bets within hours of the US and Israeli strikes in Iran. In April, Kalshi fined and suspended three congressional candidates’ accounts after discovering they voted in their own elections. 

Wisdom of Crowds and Hedging

Proponents of prediction markets argue that because they react instantaneously to breaking news, they are often more accurate than traditional polling tools. The wisdom of crowds — a concept that collective individual opinions from a large diverse group often results in a highly accurate aggregate answer — helps to accurately predict future events.

Another use of prediction markets is hedging to offset real-world risks. For example, a prospective homebuyer worried about rising interest rates can buy “Rates Stay High” contracts to offset the increased cost of a future mortgage. Institutional investors and hedge funds are increasingly turning to prediction markets with trading volumes growing 800% over the past six months. Kalshi recently executed the first customized block trade as contracts exceed several million dollars. 

The Illusion of Investing

It would be easy to think that these event contracts are investments. But prediction markets are not an investment strategy. When you invest in a stock or an index fund, you’re buying companies that build things, innovate, and generate earnings. Prediction markets are by definition a zero-sum game with a one-time fixed gain or loss. There is no interest payment, dividend or long-term compounding.

These markets are now heavily dominated by sophisticated traders using high-frequency algorithmic trading tools. The odds are stacked against the average person. More than 70% of Polymarket users lose money, and 67% of all profits go to just 0.1% of accounts. 

As the line between financial prowess and luck continues to blur it’s important to remember that not every trend is an investment opportunity. If you choose to participate, it should never replace a disciplined wealth-building strategy.

We’re no longer just reading the news, we’re pricing it. The best bet you can make is a disciplined one on your own financial literacy. Learn the difference between growing and protecting your wealth and testing how good you are at guessing who will have a #1 song on Spotify this month (btw, my pick is Bieber).