Investing Zero-Sum Games

August 26th, 2009 by Potato

I didn’t quote it in my last post on the options collar, but it has been said that “options are a zero-sum game”. Options are basically a side bet on the market: for one person to make money, another person had to take the opposite side of the bet and lose. In fact, it’s worse than that, since both parties have to pay fees.

The big problem with zero-sum games is that over the long run you can’t expect to do well (the exception being if you have the skill to take your winnings from other people). That is, after all, what zero-sum means: money/value isn’t produced out of nowhere, it’s only made at the expense of other players.

So why isn’t the stock market itself a zero-sum game? For starters, it’s because the shares represent ownership of actual (generally) profitable companies. You can expect that, as a part owner, you will share in the fortunes of the company through dividends if nothing else. Put another way, over the long term the stock market tracks the economy because it owns a large part of it, so as long as the economy itself isn’t zero sum, everyone can win on the market (and indeed, the very long-term trend has been gains above and beyond inflation in the market as a whole). This doesn’t necessarily hold for very short time periods though, such as day-trading. I’ve also heard the argument that the stock market isn’t zero-sum because there isn’t a counterbalancing position for every share: companies can issue stock (and somewhat more rarely, buy back stock), and so there are more longs in the market than shorts, so therefore it’s not zero-sum. That’s kind of a neat, symmetric mathematical/logical approach, but I like the economic explanation since it seems to have more explanatory power to me — I can see where the money for everyone is coming from.

What else is a zero-sum game? Well, foreign exchange markets are generally considered to be zero-sum games (or again, minus-sum after fees). After all, currency itself doesn’t create value, it merely stores it. There are fiddly external things that can influence that, like interest rate differential “carry trades” that are supported by other pressures maintaining an exchange rate, but for the most part if you’re thinking of following those forex ads, you should understand that the only way to make money is to bet against other people and win.

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