Tuesday, May 6, 2014

Are the Markets a Zero-Sum Game? Yes and No.

This is a common barrier that discourages new entrants to investing and the stock market.  Basically, it states that for every dollar gained in the stock market, another dollar has to be lost by another participant.  In the strictest sense, I can guarantee to you this is not the case, at least not in the long run!  If this were true, then the stock market would not have produced real returns over the last 100 years!  Since the S&P 500 consists of the vast majority of all investable US equities, the average long-term US stock investor would receive a return comparable to the long-term return of the S&P 500 by definition (at least for the US equities portion of his asset allocation.)

Over the short run, the market may seem to be a zero sum game since it's most likely not trending or moving in any decisive direction (up or down) most of the time.  Many books on short-term trading may consider the stock market a zero-sum game and they're pretty much right - the average investor doesn't gain or lose much (assuming they held through the entire period and didn't panic sell on the dips.)  There's also this notion that you must "take money" away from other (usually less sophisticated) investors in order to build your wealth in the stock market.  These people then believe that in order for them to make money at investing, someone else has to lose money which makes them feel investing is a dog-eat-dog world.

Beating the market, on the other hand, is a Zero-Sum game.  If you think about it, half of all the dollars invested in the stock market will underperform the average and half will outperform.  If the return was, say, 20% last year and you returned 40%, then there exists 1 or more investors who must have performed below the average for this logical balance to exist.  However, since the stock market has outperformed inflation over the long run, the average performing investor, assuming he/she stayed invested, would still have benefited.  (Even a somewhat below average performance would still have created wealth for many long-term investors!)

Investing isn't a race or some endeavor to steal money from other investors.  It's how the free market rewards you for bearing risk and lending your excess capital to companies that need it more.  Sure, some companies might end up being duds but if you diversify properly and hold on to a long-term attitude in your investing, your efforts will likely pay off in the end.  In future posts, we'll explore the right attitude to have when investing.

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