Sunday, October 01, 2006

Is investing a zero-sum game?

This is one question that I would like to answer a long time ago but have always thought I don't have a good answer yet. Nevertheless, I shall attempt to answer that today. Is investing a zero-sum game? I think the answer is both yes and no.

BTW, this post is talking about investing in general, which include fixed deposits, bonds, stocks etc, so not just stock alone, ok hor?

The answer is partly yes, it is a zero-sum game, because whatever you buy, you will have to sell to make a real profit (as in not just paper gain), and whoever bought it from you would be deprived from the amount that you profited. So whatever you gained, he would have "lost" (or failed to gain).

However, we must understand that the world's economy has been growing on average 3-5% p.a. for the past 100 yrs and stocks have grown at roughly 10% p.a. while bonds roughly 5% p.a. So in aggregate, investors would have earned roughly 5-8% (Hence this blog is called 8% p.a., in case you haven't realized), depending on their portfolio mix and also assuming that whatever they invested in did not go bankrupt or go into default. (Actually if they diversify, even if some investments become zero, others would have made up for it. So in aggregate their portfolios will still earn a positive return)

So this is to say, even when you sold your stock at a profit to the next guy, he will not necessarily lose money, because in aggregate, everything will grow, at the very least, with the world economy. He will at least earn 3-5%, if he simply buy government bonds, or 10% if he put everything into stocks.

In other words, the "zero" in the zero-sum is actually 3-5% (which is also roughly the global GDP growth rate) and for stocks, the zero is maybe 8-10%, depending which market you invest in. Hence the "no": as in investing is not a zero-sum game, if someone earns money, it does not mean that someone else is losing money.

To conclude, in the game of investing when you make a realized profit, you deprived someone of that profit but if the next person holds it long enough, he will not lose money, because at the very worse, his investment will grow at the same rate with global economy.

See also The Greater Fool Theory
and Markowitz Portfolio Theory
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