If the Stock Market is a Zero Sum Game, What are the Implications?

You’ve might not have heard of this before. The stock markets are a zero sum game, no matter how much you’d like to deny this fact. Here’s the definition of a zero-sum game from Wikipedia.

In economic theory (this mainly applies to stocks), a zero-sum game is a mathematical representation of a situation in which a participant’s gain or loss is exactly balanced by the losses or gains of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.

In other words, for every winner, there’s a lose. For every dollar made from speculating with stocks, someone else lost a dollar. It’s simple. But simply realizing that the stock markets are a zero sum game is useless. We need to take a look at the implications.

All stocks will eventually go to zero, given enough time.

Nothing stands forever, as the saying goes. No company (stock) will last forever. The big names of today, whether it be Wal-Mart, Google, Home Depot. All will one day be nothing but a memory in history books. Don’t believe me? Let’s take a look at the Dow Jones Industrial Average. The Dow Jones average was founded on May 26, 1896. Back then, there were only 12 stocks in the index (not 30 like there are now). Here’s what happened to them.

American Cotton Oil – no longer around

American Sugar – no longer around

American Tobacco – no longer around

Chicago Gas – no longer around

Distilling & Cattle Feeding – no longer around

General Electric – still around

Laclede Gas – no longer around

National Lead – no longer around

North American – no longer around

Tennessee Coal & Iron – no longer around

U.S. Leather – no longer around

U.S. Rubber – no longer around

Many of these were once the titans of their day, the leaders (or monopolies, which was often the case) in their market. Only 1 remains.

So one day, all stocks will go to zero. I had someone on the internet calling me an “idiot” for saying that there needs to be a sell strategy if you’re using buy and hold. He said that the whole point of buy and hold was not to sell, but instead to hold “forever”. So let’s do what this “genius” recommends. Let’s buy stocks and hold forever. Guess what? One day, every single stock in that portfolio will go to zilch. Zero.

I’m just pointing out the flaws of buy and hold here.

Don’t be fooled by the indexes.

You may be thinking “you’re wrong, Tony. Just take a look at the indexes like the Dow. They steadily increase overtime. They don’t go to zero.”

Let me tell you something. The indexes frequently kick out underperforming companies, and add new well performing companies to itself. In essence, the indexes are just making themselves better and better by selecting the best.

Investing isn’t a game that everyone will win at.

If investing is a zero sum game, there will be losers. I hate to break it to you, but there will always be investors who end up not making a cent over the course if his entire life. I just hope it’s not you, my reader. That is why, you need to educate yourself! Most people think that investing is like gambling. The love the rush of andreline when they press the buy button.

Investing isn’t a game where you can just take a glance at the financial summary of a company and invest in a profitable company. It takes skill, and persistent monitoring of the markets. That being said, if you’re not willing to be devoted to the markets (at least know what you’re doing), then it’s in your best financial interest to get out of the game. Stop investing on your own, and just put all your money in one of those 6% a year Fidelity funds.

Alternatively, if you don’t know what you’re doing, then learn as much as you can.

15 Responses to “If the Stock Market is a Zero Sum Game, What are the Implications?”

  1. JK May 23, 2012 at 9:01 am #

    What you are missing
    a) companies tend to pay dividends
    b) the same logic applies to ALL investments; bank deposits (banks fail), gold (gets stolen), houses (destroyed in fire or burn down) etc.
    c) On average, bankruptcies are a small “dent” in large cap stock portfolios. Yes, they are there. And yes, they happen to every company eventually. But no, stock portfolio are not “poised to go to zero”. In fact, run the numbers on your stocks (i.e. what would you have today if you would have invested $100, inc dividends), and I am sure your logic doesn’t hold. In fact, I bet you would be pretty rich!

  2. Pete Poggi February 28, 2012 at 10:03 am #

    The stock market is a zero sum game because trading stocks as an activity has no possible way of generating real net wealth for the total of all people buying and selling – any more then trading baseball cards. And buying stock in most cases, is not investing – the money does not go to the issuing company (unless you are talking about an IPO). Note that in this discussion, I am ignoring dividends and I am not saying that individuals can’t make money trading stocks.

    When you invest, you loan your money to a potentially profit making activity – if the activity is successfully, you are paid back your principle plus interest. When you buy a stock, your money goes to the last person(s) that previously owned your shares – and to pay a fee for the transaction. The only generation of wealth comes from the transaction fees and that goes to the brokerage. The direction of the stock price is determined by the balance of people buying vs. selling the stock – a net buying forces the price up and a net selling forces it down. The degree depends on transaction volume and rate. The point being that not everyone who holds the stock in question can cash out at a net gain. 

    If you accept the fact that the activity of trading stocks has no way in itself of generating wealth, then it it is a short path to the conclusion that trading stocks can only transfer wealth (to the brokerage and to people who sell at a gain – all from people who sell at a loss).

    Now people will confuse net wealth generation with the trend in market averages. They will point to some index and claim that if you had invested so much in the stocks that make up the index on some date and then sold years later on some other date, that you will have X times your original investment. Some even adjust the gain for inflation, to make the number seem more legitimate. 

    Now I will grant you that if everyone that invested in the markets had exactly, or even close to that result, then I would have to agree with the claim that the markets can generate wealth. The problem with the claim is that you can not point to an index to claim wealth generation. You need to take the same period of time and examine every transaction by every person over that period of time, and then sum up the net gains and losses. Doing that and adjusting for inflation and the fees in each transaction, you will find that the sum is close to zero. The reason? The activity of trading has no way to generate net wealth for everyone involved,  it can only transfer wealth. The money that went into buying stocks is transferred to those who sold at a gain and to brokerage houses as transaction fees. There are minor exceptions – as an example, some stocks pay dividends but they are fairly insignificant and are assumed subtracted out in the assertion that zero sum applies to the activity of stock trading.

    You will notice I never said that money could not be made by trading – obviously it can. My only claim is that ignoring dividends, money was not magically created out of nothing, it came from people who lost money trading.

    So then what kinds of activity can actually generate wealth? Making a real investment such as working for a living; opening a savings account, or CD; buying an individual municipal, or corporate bond, or a treasury instrument and holding it to maturity; loaning money to a friend starting a business. There is some amount of risk associated with each of these activities. An investment doesn’t always pay off, because not all profit making activities succeed. 

    The reason I don’t include bond funds is that their price can vary independently of the value of their holdings. And since their is a liquid market for both individual bonds and funds, both will fluctuate in value on a day to day basis. The benefit of an individual bond is that they continue to pay interest to the holder and there is always a point in time (barring default) when they are guaranteed to return the principle invetsed. The same can not be said for a bond fund. So while a bond fund might loose value when other investments look more attractive, there is always the interest paid and the day when principle will be returned with an individual bond.

    So the unique thing about real investments is that they have the potential to generate wealth for everyone who invests. Trading stocks can not by definition, because trading stocks only transfers wealth from loosers to winners.

  3. Invest It Wisely December 8, 2011 at 10:33 pm #

    Nothing wrong with having a sell strategy, but nothing wrong with indexing and asset rebalancing, either. A shrinking company will take up less space on the index by default.

  4. Kerrie November 24, 2011 at 6:13 pm #

    I believe the best approach to investing in the stock market is to get a good stock market education and discover how to stack the odds of winning in your favour

  5. Jackie November 11, 2011 at 6:09 pm #

    Hm, while I do think that there should be a sell strategy, I suspect that for many people who do buy & hold (which I mostly do) “forever” really means “until close to retirement” or “until I pass my stocks to an heir”.

    • Tony Chou November 11, 2011 at 6:48 pm #

      Right. But the problem lies in the fact that you don’t know if the stock market will be kind when you retire.

  6. SB @ One Cent At A Time November 10, 2011 at 10:16 pm #

    I don’t agree with you, neither do I agree with that so called ‘idiot’. I can only hold till the company is in good standing or I need cash (during retirement). It’s best to read about all your holdings regularly and make sure everything is going fine. With constant hint of trouble sell your holding.

    I can pick up 12 companies which are around for 50 years and still growing.

  7. Jeremy @ Personal Finance Whiz November 10, 2011 at 11:12 am #

    This is why I love mutual funds. I don’t have to worry about tracking the performance of dozens of companies. I don’t have to worry about them going out of business. I just make sure that the mutual funds I’m invested in perform in line or a little above the market.

  8. PKamp3 November 10, 2011 at 10:02 am #

    I think calling it a zero-sum game is a loose definition of zero-sum. Zero-sum would mean you’ve got a short backing up every long position – and when it comes to stock that’s rarely the case. When you’re talking options, futures and the like… yeah, that’s zero-sum, because those are contracts evenly balanced to buy/sell. It’s probably better to model stocks as a claim on future earnings – just because a company goes bankrupt doesn’t mean it didn’t generate wealth while it was alive. Calling stocks zero-sum also would discount dividends, which can be kept even if a company which paid them eventually goes bankrupt.

    All that said, I don’t know why someone would call you an idiot for having a sell strategy. Warren Buffett said the ideal holding time was zero… but in practice, companies, like humans, are flawed. In fact, some times stocks will become wildly overvalued even if you bought them when they were fairly valued (you might have some gains in that case). A stock may have made sense at a P/E of 10, but 50 makes you think twice!

    You’re definitely not an idiot for knowing when to sell. In fact, selling is the harder part of the whole ‘buy-sell’ game.

    • Tony Chou November 10, 2011 at 11:18 am #

      Exactly. I stopped talking to that idiot after a while. It just frustrated me.

  9. cashflowmantra November 10, 2011 at 8:16 am #

    While those specific companies do not exist, many were purchased and merged with various other companies over time. Some went into bankruptcy. I do think that you ought to have a set of rules for selling or some method of assuring profits.

    • Tony Chou November 10, 2011 at 11:22 am #

      It’s true, some did get merged. But eventually, nothing will last.

      • bananabender November 12, 2011 at 8:12 am #

        Your argument is totally wrong because NONE of the 12 Dow companies ever failed. Some merged with other companies, some were broken up and others were renamed.

        With the exception of US Leather they are ALL still in business (under different names).

        U.S Leather was wound up voluntarily in 1952 and the assets distributed to the shareholders.

        General Electric – General Electric
        American Sugar -Amstar Corporation
        US Rubber Company – Uniroyal
        Chicago Gas – Peoples Gas
        Laclede Gas – Laclede Group
        American Tobacco – British American Tobacco
        National Lead – NL Industries
        Tennessee Iron and Coal – US Steel
        Distilling & Cattle Feeding – American Spirits Manufacturing
        American Cotton oil – takeover
        North American – de-merged

        • Tony Chou November 12, 2011 at 8:44 am #

          Ok. I was wrong. But many of these companies merged because they were in a desperate financial state. But the point is, one day, nothing will last forever.

          • Funancials November 14, 2011 at 11:06 pm #

            …but what is your evidence showing that nothing lasts forever? My man banana has shown that some things do. Unless you have an 8ball, I’m not following.