Barry Ritholtz has a post about the zero-sum-ness of things. I think he's right from the perspective of most traders, but forgets that capital and hedging markets are supposed to be positive sum for economies as a whole. I tried this comment on his site, but TypePad thinks I'm comment spam, and refuses to post. Good thing I have my own danged blog.

From a trader's perspective, markets are a zero-sum game.

But equity and hedging markets, when they function properly, are positive sum games for an economy as a whole. That's why "investing" is treated differently than "gambling" from a social welfare perspective, and legal even in Utah.

Here's an example of poor zero-sum reasoning: "I bought 100 shares of WhizCo from Joe. The stock went up $10 per share therefore my gain is Joe's loss."

That's true 99.9999% of the time (and the people who criticize Barry by implying opportunity costs don't count are full of it). But the 0.0001% of the time when the seller is the firm or entrepreneur are what make capital markets positive sum.

An example: Here at WhizCo, owing to our unique mix of technology and assets, we have an opportunity to develop the ReallyCoolThing[TM]. But to do so, we require a lot if capital up front, and it's a risky venture. So, we — the existing shareholders — sell part of our stake in WhizCo by issuing stock. With the money, we develop ReallyCoolThing, and it's the best thing ever. It sells very, very well. WhizCo rakes in profits, and its stock skyrockets.

Clearly, the recent purchasers of WhizCo gained from our sale of stock. But did the sellers, the existing stockholders lose? NO, because they could not have realized the gain in stock price if they hadn't sold. There is no legitimate opportunity cost inherent in the sale, because the stock price would not have gone up if WhizCo had not sold stock to finance its project!

Stock markets don't exist for traders. They exist for firms to obtain financing for risky ventures at the lowest rational prices, so that wealth-creating ventures that might otherwise not have occurred do occur. Traders function is to price stock accurately. Traders play a zero sum game — Barry is right about that — that is esteemed more than betting horses only because it contributes to the positive sum game of discriminating between the worthy and the unworthy in the financing of risky ventures.

I would argue that stock markets have been doing a poor job of this recently for a variety of reasons, and that Barry may be right that there is so little reason behind price fluctuation now that it's best considered a zero-sum game of guessing arbitrary moves in advance. But it was not always thus, and will not be thus for long. Financial markets that forget who they are financing and why have a way of undoing themselves.

Even futures markets, the prototypical "zero-sum game" where for every long there is a short, are not in fact zero sum. Futures markets exist for hedgers. The role of speculators is to price risk. An example:

WhizCo can take year-in-advance orders from European customers because they can hedge the currency risk. When an order is placed in Euros, WhizCo buys dollars for Euros via 1-year-ahead futures positions. Knowing exactly how many dollars they will receive in a year, WhizCo is able to price its goods without assuming currency risk. They would not be able to afford to enter the European market if doing so would require them to risk selling in Euros, but getting paid a fraction of their dollar costs because the Euro has plummeted by the time they make delivery.

WhizCo's futures positions, in isolation, are zero sum games. Sometimes they gain on the futures, and someone else loses. Sometimes they lose, and someone else gains. But WhizCo does not buy futures in isolation. By hedging legitimate orders, it in fact neither gains or loses by entering into the futures trade, but exactly offsets the change in the value of its Euro revenues. WhizCo gains overall, because it would not have built a large, wealth producing business in Europe had it not been able to hedge.

Suppose, due to persistent dollar decline, WhizCo's contracts turn out always to be losers. WhizCo still gains, because their European business is profitable, and they weren't hoping for speculation gains. Speculators are happy, because they took money from WhizCo that WhizCo would never have earned if it hadn't been able to hedge. This is a win-win scenario, positive sum.

By definition, market share, or any relative valuation, is zero sum. But stock markets and hedging markets are not about rankings. They are important institutions involved in positive sum wealth creation. The zero-sum games played by traders serve to increase the total absolute sum wealth of an economy relative to what would have been, had reasonably priced hedging and risk-tolerant financing not been available.

Note: This piece actually published 2006-10-11 09:21:19 EST, not on 10-10 as shown. I set back the date, because I want yesterday's post to keep the top spot for a bit. Update: The date and ordering of posts is now correct. The previous post has had its time in the sun. (Date fixed 2006-10-15 6:28 p.m. EET)

Steve Randy Waldman — Wednesday October 11, 2006 at 10:21am permalink
grodge (mail) (www):
Excellent appraisal of nonzero sum economics. I got here from Big Picture.

10.11.2006 11:17am
Gabriel M. (mail) (www):
True, true.

If you gamble on the future, someone losses, someone wins.

But markets in commodities, for example, are positive sum... everybody wins.
10.11.2006 1:15pm
Barry Ritholtz (mail) (www):
I am not saying that everything is always a zero sum game -- not even close.

But I do believe that many more things are zero sum than people realize.
10.12.2006 10:52am
Laurent GUERBY (mail) (www):
Well, good old banks are also able to finance entrepreneurs. So are bonds. Then private equity, then public equity.
10.15.2006 7:30pm
Steve Randy Waldman (mail) (www):

Good point, but subtle.

In terms of the zero sum-ness of things, all I've really argued is that financial investment broadly is positive sum, if it means that at least some profitable projects that would not otherwise have been funded (or whose risks would otherwise would not have been undertaken). I've glossed over "which form of investment", as if public capital and risk markets were the only option.

The question of whether, say, a stock market is poistive sum given other capital sources, is an emptical question based on the efficiency of stock market capital allocation vs other sources. (A similar question applies to public futures markets vs private insurance or OTC forward contracts.) If public markets are more efficient than, say, bank finance or private equity in both choosing good projects and financing them at adequate scale, then public markets are net positive sum. If they are always less efficient, they are negative sum, and we'd all be better off if everyone deposited money with smart banks. If there are certain conditions under which public markets are more efficient financing vehicles, and others where banks or private equity are better, you'd need a very detailed analysis to decide whether the marginal dollar allocated to public equity is "positive sum" or not, and what the optimal allocation to different allocative institutions should be.

These are important subtleties. And more practical than I'm making them sound. I think that it's a big question mark right now, given how public capital markets are actually behaving and the possibility that they are overfinanced, whether a dollar added is currently "positive sum". This is particularly true if we view opportunity costs not only with respect to existing bank finance, public debt, and private equity, but also vis à vis plausible alternative institutions.

I think we can come up with much more efficient capital allocation schemes than existing public and private markets, so from my perspective, an extra dollar's capital is "positive sum" with respect to a world without any reasonable means of pooling and allocating capital, but negative sum with respect to a world where the added finance went to "more optimal" institutions. But obviously, this last bit is very speculative.

Thanks for a good (and very succintly made) point. (I wish my response were as elegantly concise.)
10.16.2006 9:38am
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