“My guiding principle is that prosperity can be shared. We can create wealth together. The global economy is not a zero-sum game.” -Julia Gillard
Investing Pioneer – 04/18/2023 – 12:50 PM EDT
Peter
I write about the economy, business, the stock market, and other markets, covering principles, methodologies, and news.
A zero-sum game is one in which there are an equal amount of winners and losers. If someone makes $1,000,000, someone else lost that $1,000,000. For example, a boxing match is a zero-sum game if measured only by losses and wins. Monetarily, however, the story can be different.
A common misnomer is calling the stock market/ equity market in general a zero-sum game. Over the long run, the stock market has generated positive value (making it a positive-sum/non-zero-sum game). Though some lose over any given time interval, the cumulative tally of wins and losses brings the aggregate outcome of market participants positive.
The purest example of true zero-sum games in the stock markets is options or derivatives trading. If an individual investor (or trader rather) buys a call option in AAPL (Apple), with a strike price of $300, and the price is at or above $300, the writer of the call will need to pay up at expiration (with shares). On a 1 v 1 basis, however, options trading is not necessarily a zero-sum game, because the seller of the option could have been hedged. On the aggregate level, including all traders, it is considered zero-sum.
Over the past 20 years, the average annual return of the S&P 500 index was 8.91%. On an aggregate basis, this can not a zero-sum, far from it. As productivity and wealth rises (economic growth), as it has for humanity for decades and centuries, the stock market has followed (with plenty of volatility in between). For example, investing in a couple of decent mutual funds (or index funds, etc.) long-term is not zero-sum.
Example of Zero-Sum Games
Speculative Rallies
With an influx of capital and interest, usually coupled with popularity and high sentiment among retail investors, the share price of a company rises rapidly. As the true value of the underlying asset or security is not properly considered, a disconnect between price and value occurs. The value of some speculative assets is near zero, whereas some can have significant value, but just not as much as the market believes it has during a speculative rally.
Some even consider this a negative sum game. Via the principle of how gambling is a zero-sum game, such rallies are as well. However, the capital transacted over that time period (that could have been used for a more productive purpose), coupled with any potential fees and time wasted, can make it so that it is considered a negative sum game.
Game Theory
Game theory is a mathematical and theoretical way of deriving how a set of actors interact will each other and the outcomes corresponding to the individuals participating. It is often and probably most applied to economic theory. Nash equilibrium falls under game theory, “that states a player can achieve the desired outcome by not deviating from their initial strategy.” (source)
Market participants who have a tendency to speculate most often find themselves in zero-sum game situations. Despite the fact that on the aggregate there are no gains, it does not necessarily mean that any individual who is involved in the zero-sum game does not profit more often than the average. This can be due to an understanding of trends and social dynamics or even unfair practices.
Examples of Speculative Cycles
1) Tulip Mania
A classic example of a zero-sum game is the Tulip Mania of 17th century Netherlands. By virtue of the fact that prices would eventually need to come back down, as interest and popularity in such things are usually short-lived, and usually sparked by fear, it indeed largely classifies as a zero-sum game.
On the other hand, given that the productive capacity of the economy continues to grow, via more food, more energy, better technology, etc. the growth in the economy can sustain rises in the share prices of indexes like the S&P 500. This association is not perfect, however. Speculation or overpricing can occur at any time frame. For the roaring 20s (1920s), which were driven by relaxed lending standards, the use of leverage, and the onset of new traders and investors a “blow off top” in the late 20s made the general stock market overvalued relative to the economy. Or in other words, the cumulative value of the stocks that made up the stock market.
When confined to the time frame from before the collapse to after, and for active participants, it indeed was a “zero-sum-game”.
Revisiting the topic of the reasons for a “negative-sum game”, a Thomas Jefferson quote captures one of the effects of speculation:
“Our public credit is good, but the abundance of paper has produced a spirit of gambling in the funds, which has laid up our ships at the wharves as too slow instruments of profit and has even disarmed the hand of the tailor of his needle and thimble. They say the evil will cure itself. I wish it may; but I have rarely seen a gamester cured, even by the disasters of his vocation.”
–Thomas Jefferson to Gouverneur Morris, 1791. ME 8:241”
2) The Roaring '20s
As discussed above, the 1920s indeed permitted many rallies and can be broadly characterized as such as well.
3) The Dot Com Tech Bubble
Amazon saw its share price fall 90% in the collapse following the dot com bull market.
Bonus: crypto markets
Though I have selected three of the most well-known speculative events in history, it should be noted that speculation and commensurate price action in shares are quite common. When conditions are favorable for speculation, which usually derives from central bank practices (monetary policy) and governmental policy, the general market can be characterized as speculative. Comprised within are multiple separate speculative components, as well as depressed components (on a relative basis).
Day Trading
Both day trading and high-frequency trading are largely considered zero-sum games. On the contrary, long-term value investing is not.
However, trade in general is not a zero-sum game. It is the very basis of our economy.
“If they think there’s easy money to be made, you get a rush,”
– Warren Buffett
Indeed, fast money is often associated with no net benefit.
Central Banks
If the financial markets are in a bubble, systemic risks may arise. Central banks can opt to continue without a correction, which is always painful for a period. As time goes on, the extent to which the markets will correct generally rises. The above is general market cycle wisdom. This general dynamic, over a certain time interval, can foster zero-sum games for active trading participants. In other words, those who drive prices beyond where they should be as dictated by what the true value of say, a share is.
Win-Win Situations
Though over the long term any given transaction, it is not necessarily win-win, aggregate levels make participation in the stock market a win-win situation. In an individual, singular transaction between two entities, where, say, someone sells a share of the S&P 500 for a certain number of dollars, it can still be considered a win-win, as the utility value of having those dollars at that point may have been higher than that of the individual who purchases a share of the S&P 500 and vice versa.
Speaking about utility values, an interesting question that is asked is what the value of investors like Warren Buffett is to the economy and society in general. Well, it concerns efficient capital allocation. In other words, who, or rather what (company) is deserving of capital?
In the stock market, it can be hard to quantify the utility of any one given investment for the company. However, as far as the value of investors, a person like Warren Buffett can move the needle for companies (by virtue of the amount of capital they obtain via the exchange between shares/ownership for $ which can then be invested into operations. If Warren Buffett is investing in the company, it’s likely that those dollars the companies used return a profit.
On the other hand, the value of certain zero-sum games like massive speculative rallies is generally negative, other than serving as a catalyst for legislation and policy to prevent future events. History repeats itself… or rhymes.
Conclusion
As for the question “Are stocks a zero-sum game” the answer is, it depends. Over certain periods, and for certain trading methodologies, it can in effect be so. Overall, however, stocks are definitely not a zero-sum game.
This is not financial or investment advice. The content is for educational purposes only.
