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.
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|