Is investing in the stock market a Zero-Sum Game?
Happy Chinese New Year and happy holidays! Hope you all had a good break and I certainly did!
In this post, I want to share one of the recurring thoughts I have as an investor in equities for some years now.
That is… Is investing really a zero-sum game?
What is a zero-sum game
Zero-sum game is a situation where one person gains and another person loses by that amount. Simply put, it’s called a zero-sum game because the winner is better off by the same amount that the loser is worse off – the sum of which comes to zero:
- Winner: +1
- Loser: -1
- Total sum: 0
Following on from my last post’s theme of gambling, the nature of gambling is a perfect example of a zero-sum game.
When we win in a gamble, we know that there is at least one person (be it the banker or another player) who lost the amount of money that we won.
Is the stock market a zero-sum game?
Here’s my take on this.
When we invest in the stock market, we buy or sell shares of a certain company. There must be someone at the other end who takes up the opposite position from us, right?
As all investors know, there are only 3 ways a share price can go after the trade happens.
- Up
- Down
- Nowhere
To keep things simple, let’s look at a 1 transaction 2 parties scenario.
As a buyer
As a buyer, we want the share price to go up so that we can sell at a higher price to profit from the trade. However, this also represents a loss of potential profits for the seller because they no longer hold the shares.
This effect is more apparent if the seller was selling to cut losses.
Imagine that the seller was losing RM1,000 on trade A when he/she sold the shares to us. Then the share price went up and we made RM1,000 on trade A. If the seller were to hold the shares, he/she would have recuperated the losses. But alas, things are never that simple in investing.
(Buyer +1,000, Seller -1,000)
If the share price were to go down another RM1,000 instead, we would accumulate losses of RM1,000 and the seller will be very glad that he/she already left the trade lest he/she loses another RM1,000 (total of RM2,000 losses).
(Buyer -1,000, Seller +1,000) -> although for the seller this is the case of losses avoided rather than making profits
As a seller
The opposite will happen if we were the seller.
If the share price goes up, we would have lost the opportunity to make more profits whilst someone else does.
If the share price goes down, we would be glad that we sold the shares already, but someone else who bought our shares will bear the losses on those shares.
Scenario
Some may be tempted to say that potential profits and losses avoided do not affect the buyer / seller in actuality. I beg to differ.
Let’s assume we have a capital of RM1,000 and we began with Trade A.
- Trade A gave us RM500 profit (50%) and we decided to sell
- We now hold on to RM1,500 in cash when buyer A took the shares from us
- If Trade A’s price increases another 50% thereafter, our cash remains at RM1,500 but buyer A enjoys the upside of RM750 (= RM1,500 * 50%). Would you not agree that we have passed on the winnings to buyer A?
- If Trade A’s price retraced the gains thereafter, our cash remains at RM1,500 but buyer A suffers a loss of RM500 (being the profit that we got from Trade A). Now, would you not agree that we are better off because we left the trade and buyer A had to suffer the losses in our place?
Final Thoughts (& the float)
In this way, I believe that investing is a zero-sum game. One gain leads to another’s loss, vice versa.
This is because we invest in the stock market with a fixed pool of shares available (aka – the float). The float represents how many shares are available in the market for trading and will be fixed unless the company goes through corporate exercises.
Read more about common corporate exercises encountered here.
Every buy order will need to be met with a similar sell order.
The prices will move according to the volume of the buy/sell due to demand & supply of the same basket of shares. This is important to know because although it is a zero-sum game at the individual level, investing needs to take into account what the market sentiments are as that is what ultimately decides whether the buyer / seller wins.
With that said, the investing community invests based on each person’s own risk appetite and outlook on each investment / company / economy. That’s why there’s always the famous BULL vs BEAR argument.
Hence, it’s all good. May the best investor win!
Happy investing and make sure to follow BTM’s Facebook, Instagram and Twitter for updates!
