Prediction markets shouldn't be so easy to play

A great financial economist once tried to convince me that retail investors should not be allowed to buy individual stocks. I strenuously disagreed: Wasn’t this America, the country that encourages risk-taking? Why shut regular investors out of the chance to get rich?

I have now come to realize that he has a point. Most people don’t know what they are doing. Buying individual shares, as this professor argued, is like buying a spark plug for a car; it is only useful as a part of a whole, in this case a diversified portfolio. Most retail stock-pickers will underperform the market.

I realize that there are already many financial regulations that try to steer investors to better decisions. These safety precautions go beyond the finance industry, and they exist not just to impose a nanny state. The government is justified in restricting risk if an individual’s decisions pose harm to others (that’s why there are speed limits), or if they are unable to acquire the information necessary to make an informed choice (that’s why there are rules about food labels).

To some extent, investing in individual stocks meets these criteria. Retail investors have less money and time to do research than the big institutional investors they are betting against. If they just buy index funds, they benefit from a rising market. But when they day-trade, they are locked in zero-sum game where their small size puts them at a disadvantage. This natural inequity can sow distrust in markets.

Yet the idea of banning individual stock-trading never left high-minded discussions in the faculty lounge because this kind of trading was never a big problem; few people did it. It took time and effort, like phone calls to an actual stockbroker or a visit to an actual office. Now things are different. You can day-trade on your phone while waiting for your coffee at Starbucks.

It’s not just stocks. Lots of risky financial behavior is being normalized or even encouraged, thanks not only to technology but also to new regulations that blur the distinction between investing and gambling.

Access to private assets was once restricted to accredited investors, who have at least $1 million or professional expertise; now you can invest your 401(k) in them. Legal gambling once required a trip to Las Vegas, or maybe a casino on a Native American reservation; now you can bet from your phone as the game is played. And the list of things you can bet on is almost endless: the next CPI report, how much it will snow tomorrow, the color of Gatorade poured on the winning coach at the Super Bowl.

The old rules may have been heavy-handed, but they were there for good reasons. Private assets were available only to an accredited investor because information about them is incomplete and they lack a market price. Gambling was once illegal in most states because there is scope for negative externalities to society, and some people will not make good decisions on their own behalf.

These costs are already evident. Problem gambling has increased, especially among young men, and there is more cheating in sports. Blue Owl Capital, which aims to provide access to private markets to retail investors, had to freeze withdrawals on one of its funds when faced with big losses. Kalshi is aiming to crack down on inside information, even getting ahead of regulation. There is also uncertainty as betting markets contend with questions about ethics and where the limits should be. Some gamblers who bet on regime change in Iran, for example, were surprised to learn that betting on the death of a leader doesn’t pay off.

As the line between gambling and investing becomes more blurred, odds are (sorry) that there will be more problems. The danger is how all these bets fare when there is a market downturn. A high-risk portfolio looks good when the market is up. But when the market turns, being overexposed and overleveraged can be catastrophic. A market crash amplified by risk brings about relatively more wealth destruction — and more distrust in markets.

To some extent, this is a failure of regulation. After years of outright prohibition, gambling markets are opening up just as technology makes them more accessible. The time to think about a better way to reduce risk-taking is before a crash happens; reactive regulation tends to overreach.

The objective should be to minimize externalities while promoting transparency and better individual decision-making. This doesn’t have to mean more prohibitions and disclosures. A more effective tack could be just making gambling harder to do — re-creating the stockbroker hurdle, for example, by restricting sports gambling to in-person bets. Or maybe regulators could create a new category of accredited investor for those who want to bet on nonfinancial assets. Whatever happens, the goal should be to force everyone to be more thoughtful about the risks they take.

This column reflects the personal views of the author and does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of "An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk."