A zero sum game is a game or transaction where the gains of one side are mirrored exactly by the losses of the other side.
Investors often hear the phrase zero sum game used negatively to describe the stock market. The idea, however, comes from economics and is neither negative nor positive.
Rather, it describes any game in which one side wins and the other side loses.
For instance, consider the kid’s game “rock, paper, scissors.” In every round, one player clearly wins while the other clearly loses.
Gambling is a good example of a zero sum game in action. Poker players put in money, each contributing the same amount at the game’s start.
By the end of the evening, one player will have the most money. Since no money has left the table, those winnings will equal exactly the losses of the other players.
You sometimes hear zero sum game used to describe stock market investing. That line of thinking has a certain appeal.
After all, if you buy a single share of stock for $100 and it goes up in value, it feels like you have “won” money that the other investor has “lost.”
Yet that’s not really true. Every investor who has owned that share might have experienced an increase in the value before selling.
Plus, that calculation leaves out dividend income payments, which are part of stock’s total return.
A dividend of 2% a year, for instance, can be reinvested back into the holding, greatly magnifying the compounding effect of holding the stock over a long period.
The reason people confuse investing and zero sum game theory is that the daily trading process does imply that there are two sides to every transaction.
There is a side that is convinced that the time has come to get rid of a stock and a side that believes it’s time to own the same stock.
Can both sides be right? Yes and no.
In the case of highly speculative stocks, traders run the risk of getting caught up in trading regardless of the underlying prospects of the company itself.
The resulting trading feeds back on itself, creating the illusion of hidden information and, thus, value. Traders begin to confuse volatility, the up and down movement of a stock’s price, with demand.
Eventually, of course, the trading settles down. The last trader to buy the stock may well feel like the loser in this scenario, while all of the other traders before appear to be the winners.
The key to better long-term investing is to avoid the type of hot potato trading that can create a zero sum game outcome.
Instead, investors should own a diversified collection of stocks closely aligned with the economy’s future growth.
Trading can and should occur, but usually only to rebalance a portfolio or in a bid to better follow a broad stock market index.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.