Game theory, as outlined by psychologists, economists, political scientists and a bunch or other intelligent folk, suggests there are three types of “games”, broadly speaking.
The worst type of game is a Negative-Sum Game where participants as a whole leave the game with less than they started. Nuclear war and games of chance at casinos are examples of negative sum propositions. For Gamblers (unless you own the casino) statistically you’ll lose a piece of every chip you bet. The sum of trips to Vegas will show that a Gamblers’ “bad luck” outruns their “good luck”. If they continue to play, Gamblers’ assets will deteriorate.
A Zero-Sum Game on the other hand is benign. Players, in aggregate, neither win nor lose – each win is matched by a loss and the sum of all results is zero. Two soccer teams playing to win a match face a zero-sum proposition. One team will win the other will lose (or they’ll tie 0-0 which seems to happen annoyingly often). Those who play the financial version of this type of game can expect every $1 gain will be paired with a $1 loss.
Fortunately, there is a third type: the Positive-Sum Game where the game itself has a net productive effect. The whole ends up greater than the sum of its parts; participants leave the game with more than they started. Marriage (yes I’m a newlywed), cooperation (the kindergarten variety) and farmers’ markets are positive-sum propositions. From an economic perspective, positive-sum games form the basis of prosperous societies. Citizens contribute to a better tomorrow by sharing their time, effort, expertise, skill, and money. Sharing your money is the basis of capitalism. Smart Investors who share their capital can expect fair rates of return in similar fashion to those who contribute their time, effort, expertise and skill.
In the financial arena, all three of these types of games are played out every second of every day. Gamblers destroy their capital in negative sum games; Players swap gains and losses punch for punch with each other in zero-sum games…while Investors quietly enjoy the steady wealth creation of the positive-sum game that is true capitalism.
So, when you invest, you want to be an Investor.
The challenge for personal investors is that it’s difficult not to be seduced by the Gamblers and the Players. Currently the sexiest areas of finance are options (derivatives), foreign exchange, and active security picking. The problem is that all of these are at best zero-sum propositions.
Stock options (as opposed to the underlying stocks themselves) are, by definition, not wealth creating. An option is written by one participant and bought by another. It’s a side bet. If I win, you lose. Factor in trading costs and we’re probably talking about a negative-sum proposition.
Foreign exchange offers the same trade-off – all currency values are simply relative to another creating a multitude of win-lose contests.
Tactical stock plays involving short holding periods are also zero-sum games. If now is “the right time” to buy a particular share of stock then you must find someone who thinks it’s “the right time” to sell you those shares. Only one player will get lucky.
By contrast, holding bonds, real estate and stocks for longer periods of time is true investing. An investor can expect to receive a fair return through interest, dividends and growth for sharing their capital and thereby owning a piece of industry. Certain mutual funds and exchange traded funds are great vehicles by which to participate in positive-sum investment without being pulled into Players’ or Gamblers’ games – others are not. If your stock broker or fund manager says they will “beat the market”, realize that they can only do this by winning a contest against another broker or manager who is probably promising their clients the same thing… after all, “the market” is simply the average of all such participants
Morningstar just reported that last year 79% of US large company mutual fund managers underperformed the S&P500 index. Since the S&P 500 is an average, this means generally that 79% of managers lost to 21% of managers – or would have done if investing was free. Once we consider fees this game of trying to “beat the market” starts to look more like a casino than a soccer match.
But this is actually all good news! Investors (and their Advisors) can proudly ignore the market noise created by Gamblers and Players (there’s a lot of it) and instead focus on Investing through appropriate allocation amongst various positive-sum capital markets. This starts with understanding risk exposure and then diversifying over the long term…other articles for other days.
Written by Ian Collings