Does there need to be a loser for every winner when it comes to investing and economic growth?
Topics covered include:
- What are zero-sum games
- How trading can be a zero-sum game
- Why active management and seeking excess returns through security selections or country weights are zero-sum games
- Why the U.S. stock market has outperformed the rest of the world
- Why economic growth overall is not a zero-sum game, but some aspects of the economy are zero-sum games
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 432. It’s titled “Are the Economy and Financial Markets Zero-Sum Games?”
Zero-sum Games Defined
One of the most thrilling and heart-wrenching aspects of sports, particularly annual NCAA basketball tournaments, is watching a team come from behind and win in the final few seconds. There’s this sheer joy and delight of the winning players and fans.
And the shock, disbelief, and even tears of the losing players and fans, who realize their season is over. I recall attending an NCAA tournament game with my father’s alma mater, Xavier University, being in the stands with him and seeing the opposing team make a last-second shot. And the roar of the crowd for the other side, and the disbelief in seeing our team lose.
A basketball game is a zero-sum game. In order to have a winner, there must be a loser. Federal Reserve economist Eric R. Nielsen describes a zero-sum game as follows. Mathematically, a zero-sum game is one in which the sum of all the gains and losses made by all the players must be zero. This is the familiar idea that one man’s loss is another man’s gain.
Nielsen gives an example of a game of poker, where the total amount of money in the pot at the end of the game is the same as at the beginning. Money made by one player with a winning streak comes at the expense of the other players.
Financial Zero-sum Games
There are some aspects of financial markets that are zero-sum games. Trading commodity futures, for example. If I go long oil, expecting oil to go up in price, and if the price of oil rises more than the price of the futures contract when I initiated the trade, then I’ll make money.
But that money that I earn comes from the trader or traders on the other side of the trade, who were shorting oil, speculating that it would fall in price. The zero-sum game of commodity futures, of currency trading is one reason they’re so incredibly difficult to get an edge in order to make money.
Seeking Excess Returns
Another example of zero-sum games is trying to generate excess returns, or alpha through security selection in the stock market. Nobel laureate William Sharpe, in a piece from 1991, titled “The Arithmetic of Active Management”, he described why mathematically active managers underperform the market.
He writes “Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using the beginning market values as weights.” What that means is the return of let’s say the S&P 500 index, a measure of US large-company stocks, its return is the weighted average of the underlying individual stocks that make up that index.
Sharpe continues, “Each passive manager will obtain precisely the market return before costs.” So that’d be an index fund, a passive ETF. And then Sharpe says “From this, it follows as the night from the day that the return on the average actively-managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also”.
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