Is the stock market a zero sum game?

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bromion

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This has probably been discussed before but I didn’t find any relevant results in a search.
So, what do you guys think? Is the stock market a zero sum game? This might be a stupid question, but I’ve been thinking about this lately and decided to see what I could find on the internet. There does not appear to be any widely held consensus. The two main camps fall out as follows:
1) The stock market is a zero sum game. For every buyer, there is a seller. If the price of the stock goes up after the seller sells, then that is the buyers gain (paper gain until realized) and the sellers “loss.” If the stock goes down, then the buyer provided liquidity to the seller, representing the seller’s “gain.” Over the sum of transactions in a particular ticker, some people gain, while other people experience a directly proportional loss (i.e., the actual value created across all transactions is zero, implying that the market is just a wealth redistribution vehicle). This is net of dividends and commissions – for example, if you included commissions, it would actually be a negative sum game (as stock brokers extract value from the process).
2) The stock market is not a zero sum game because stocks are not merely pieces of paper, but shares of an actual business entity. Each business creates or destroys value based on a variety of factors, but on a net basis, more value is created than not. Shareholders in these companies benefit from this value creation, thereby negating the zero sum argument (i.e., the total value of the market fluctuates but keeps going up over time, the current crisis not withstanding).
The problem I have with argument two (which I may not have done justice to), is that the actual value creation does not directly effect the price of the company’s shares. If the company comes up with a new product and that sends sales up 30% Y/Y with, say, a 40% increase in earnings (op leverage), that doesn’t send the value of the shares up some commensurate amount ON ITS OWN. If the shares go up, it’s because people have the PERCEPTION that the shares will be worth more in the future, and they therefore bid them up hoping to make money on their investment. In this case, no “value” is created by the business as it relates to the shares per se, just that the underlying business performance colors people’s ideas about what the shares might be worth in the future. This is why shares trade on future expected value, not on current value (i.e., the stock market is a discounting mechanism for the future).
If you think about it in these terms, then as a hedgie or some other smart money investor (it might be a stretch to call some hedge funds smart money, but roll with me here) “exist” to extract value from dumb money (i.e., mutual funds and retail investors and people who trade based on Cramer’s advice). Did I miss something or is this pretty much the bottom line? I didn’t start thinking about the market in such competitive terms until I started working at a hedge fund and realized that a lot of our investment decisions are geared toward extracting value from bad sell side analysts that move stocks as well as other investors who routinely fall into certain predicable “traps” in the market – we view these people as sources of liquidity, both on the long and short sides of a particular stock.
Long post, so thanks in advance to people who respond with insightful comments.
 
former trader Wrote:
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> Options and futures are zero sum game.
Yes, I know that.
 
“The stock market is a zero sum game. For every buyer, there is a seller. If the price of the stock goes up after the seller sells, then that is the buyers gain (paper gain until realized) and the sellers “loss.””
I disagree. A loss is when the seller has to actually pony up the difference, like in the derivatives market.
Using your reasoning, someone who buys a stock at 20$, sells it at 100$ and then the stock goes to 300$ has a net loss. Yet, in the real world, he has 80$ more in his pockets.
 
former trader Wrote:
——————————————————-
> Using your reasoning, someone who buys a stock at
> 20$, sells it at 100$ and then the stock goes to
> 300$ has a net loss. Yet, in the real world, he
> has 80$ more in his pockets.
I didn’t say that opportunity costs create real losses. It doesn’t really matter what happens in one particular scenario, which is why I said the sum of the total transactions equals zero. Individual transactions are whatever they are. This particular guy made money, and maybe nobody lost money yet (assuming a completely straight trajectory where the price is higher each day, including on an intra-day basis, which would never happen in reality). So everyone is a winner so far in this scenario.
Say that the company is cooking the books and making the numbers look great, so the stock rises to 300, which necessarily means that people are putting more capital into the shares (it doesn’t rise out of thin air). At 300, the knowledge that the company is cooking the books becomes public and the shares drop to 0. The guy who bought at 300 provided a lot of liquidity to anyone selling at that price. And as people are dumping the shares, they are effectively taking liquidity out of other people who bought the shares along the way to the rise to 300.
Using price per share numbers can confuse the logic here. It’s much easier to think about this in terms of total capital invested in the shares (market cap). It’s kind of like a giant game of poker with a pot in the middle. People are putting money into the pot and taking money out of the pot all the time, but the game doesn’t actually create a larger size pot on its own – the only way it gets bigger is when people add more to it. And when everyone pulls money out of the pot because the shares go to zero, then some people necessarily came out better than others in an amount that directly offsets.
I guess in a bankruptcy scenario where capital is destroyed (the price never goes to exactly zero), that would represent a destruction of capital of the residual amount, which means its not exactly zero sum, only effectively zero sum. It seems like it would be zero sum if the price could actually hit zero, though.
Anyway, I could be wrong about this, but I don’t think your example disproves the idea that it’s a zero sum game.
 
No. I wouldn’t net the seller’s foregone gain with the buyers gain to calculate the net gain.
By your logic, the massive creation of wealth between 1955 and 2007 was a zero sum proposition because you consider the foregone gains by sellers an actual loss.
 
joemontana Wrote:
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> No. I wouldn’t net the seller’s foregone gain
> with the buyers gain to calculate the net gain.
>
> By your logic, the massive creation of wealth
> between 1955 and 2007 was a zero sum proposition
> because you consider the foregone gains by sellers
> an actual loss.
I may have written this poorly above since my original post seems to be confusing people. I’m talking on a net basis (read the last post), as opposed to an individual transaction basis.
Also, of course the market went up – there have been greater capital flows to the market, not to mention inflation. Just because there is more capital in the market at any one given time doesn’t mean that the market created value.
Anyway, I am not defending the idea that it’s a zero sum game to the death here, but I would like to hear a convincing argument for what it isn’t if that is the case.
 
The loser in the stock market are the later participants. Stock market is more than a Ponzi scheme. Do you think Ponzi scheme is a zero sum game?
 
A ponzi scheme is a zero sum game. The stock market is perhaps the most powerful wealth and value creation system ever set up. See the difference?
The market doesn’t create value in and of itself - humans do that through innovation, productivity and entrepreneurship. The stock market allows that to be measured, transferred and monetized.
This crap about putting capital in versus capital destroyed in meaningless. You’re arguing about several things there, and most of them related to efficient markets, not the ability of the stock market to create value, or of investors to capture that value.
 
What I don’t understand is if the stock market and derivatives are a zero sum game then how did the current economic downturn destroy so much global wealth? If the capital markets act to redistribute wealth then shouldn’t the net change to global wealth be zero?
 
The stock market is not a zero sum game, at least over long periods of time. On average, it is a positive sum game, because wealth is created as the economy becomes more productive and discovers better ways to meet human needs. Whatever wealth is created by companies with listed stock falls to the bottom line and increases the stock value (neglecting debt for the moment). There are times like these where the economy is contracting and the stock market is a negative sum game.
It is also theoretically conceivable that the economy could be growing but public companies aren’t the ones that are generating the growth, but I don’t know of any historical cases of that since the use of public stock became commonplace.
In any trade, there could be a winner and a loser, but over time, the average winner gains more than the loser loses, because the winner (usually the stock buyer) is disproportionately benefiting from the leveraged exposure to economic growth that equities give you. The shorter the time period under consideration, the closer the stock market resembles a zero sum game.
 
Just like the economy, there are two reasons why a stock market can grow in the fundamental sense. One is population growth and the other is productivity growth. The population growth part is what makes it a ponzi scheme. The productivity growth part is what makes it deviate from a ponzi scheme
 
stocks and bonds are earning assets. all else equal, you make money holding an earning asset. options and futures are not, hence they are a zero sum game.
 
bchadwick Wrote:
——————————————————-
> The stock market is not a zero sum game, at least
> over long periods of time. On average, it is a
> positive sum game, because wealth is created as
> the economy becomes more productive and discovers
> better ways to meet human needs. Whatever wealth
> is created by companies with listed stock falls to
> the bottom line and increases the stock value
> (neglecting debt for the moment). There are times
> like these where the economy is contracting and
> the stock market is a negative sum game.
How does a more productive economy cause wealth to drop to the bottom line on a stock? It does create earnings growth, which causes people to bid up the price of a stock. I agree with that. But it doesn’t fundamentally create wealth. Wealth doesn’t manifest itself out of thin air in the form of higher stock prices because Microsoft creates Windows or Apple creates the iPhone. The stocks rise and fall based on people’s capital allocation decisions, which are based on expectations about the future of those companies. So the stocks rise based on perception, not actual real wealth creation.
In fact, I think what you are saying supports the argument I was making. (BTW I’m being the devil’s advocate here in making that argument since I am not sure what is right). If the market is expanding, that implies more capital is entering the market, and if it is contracting, that means capital is exiting the market. The expansion or contraction has nothing to do with wealth creation per se, just capital entering and exiting the market based on perceptions. So it seems like you are agreeing with what I wrote earlier.
If there truly is wealth being created here, can you explain how?
Edit: I can see how a more productive economy creates more total wealth, which in turn leads to a higher stock market, but that’s not the same thing as a more productive economy fundamentally raising stock prices. All it means is that there is more wealth chasing fewer stocks, so as with any supply demand relationship, prices rise.
 
NakedPuts Wrote:
——————————————————-
> A ponzi scheme is a zero sum game. The stock
> market is perhaps the most powerful wealth and
> value creation system ever set up. See the
> difference?
No, because you didn’t really say anything here. Can you explain your argument?
> The market doesn’t create value in and of itself -
> humans do that through innovation, productivity
> and entrepreneurship. The stock market allows
> that to be measured, transferred and monetized.
Right, this is what I said.
> This crap about putting capital in versus capital
> destroyed in meaningless. You’re arguing about
> several things there, and most of them related to
> efficient markets, not the ability of the stock
> market to create value, or of investors to capture
> that value.
No, what I said has nothing to do with efficient markets. Whether the markets are efficient or not is meaningless to the discussion. What I am saying is that prices rise and fall based on perceptions that lead to capital flows, not real wealth creation. Whether all of these expectations are impacted in current prices doesn’t change the net effect of the capital flows. Also, which particular investors capture the value is not related to the discussion. Clearly, some people capture a lot of value (and become billionaires) and, seemingly, many others lose value in order to make that happen.
 
I’m running somewhere, but will try to respond to this later. But is your question about whether economic growth is actually a wealth creation process or just a question about whether that wealth is ever actually reflected in the stock market?
 
regarding the buyer/seller comment:
If you buy a stock from me, I receive cash you receive stock. if the stock goes up, we both make money, I return interest on cash and you profit from the stock appreciation plus potentially dividends. If the stock goes down, I still make money on my cash and you lose.
If when I sold you the stock I was short the position rather than receiving cash then you could say the stock market is a zero sum game if there were no dividends. (i.e. stock goes up you win I lose, stock goes down I win, you lose). this however is not how the stock market works.
 
bchadwick Wrote:
——————————————————-
> I’m running somewhere, but will try to respond to
> this later. But is your question about whether
> economic growth is actually a wealth creation
> process or just a question about whether that
> wealth is ever actually reflected in the stock
> market?
I know economic growth is a wealth creation process. I can’t see how this relates to wealth creation in the stock market. It seems like the wealth creation that happens in the economy influences the stock market – i.e., incomes increase, so people have a larger amount of investable funds. Those funds, if placed in the stock market, increase the value of the market (i.e., total market cap goes up). That doesn’t mean the stock market actually created value, though, it just means it went up because of increased capital allocation. So, if you are saying the stock market creates value, I am asking “how?”
 
I agree with bromion. Unless I’m missing something, no one has provided an explanation for why the stock market isn’t a zero sum game.
It’s clear econonic growth creates value and wealth over time through innovation and improvements in technology. However, this value does not automatically translate into higher stock prices UNLESS investors allocate more capital into the market and bid up prices.
If through some mechanism stock prices were able to move up or down independent of capital inflows/outflows, then THAT would dispel the zero sum notion.
 
Dermot81 Wrote:
——————————————————-
> I agree with bromion. Unless I’m missing
> something, no one has provided an explanation for
> why the stock market isn’t a zero sum game.
>
> It’s clear econonic growth creates value and
> wealth over time through innovation and
> improvements in technology. However, this value
> does not automatically translate into higher stock
> prices UNLESS investors allocate more capital into
> the market and bid up prices.
>
> If through some mechanism stock prices were able
> to move up or down independent of capital
> inflows/outflows, then THAT would dispel the zero
> sum notion.
Yes, I think part of what might be confusing about this is that unlike other zero sum transactions, the market doesn’t force the parties to net out gains and losses most of the time – i.e., the duration of the “bet” is potentially infinity, as opposed to a six month futures contract, or whatever. This is what I was trying to get at with the bankruptcy scenario – that if a price went to zero and the market effectively “forced” reconciliation of all gains and losses less the residual, then it would be clear that it was a zero sum game across *all* transactions, regardless of the outcomes of individual transactions.
In most cases though, stocks don’t go to zero. Microsoft has a market cap of $167B, for example. I think most of us would agree that MSFT is not going away any time soon. It’s market cap reflects an implicit agreement by holders of the stock about the company’s underlying worth. In other words, it doesn’t go to zero because holders “agree” to believe it has some value above zero, in this case $167B. As long as the market believes there is value, the zero sum reconciliation does not occur. If the price of MSFT falls to whatever arbitrary measure of “cheapness” people use, others will put capital to work in the stock with the expectation of making future gains.
In this sense, because we are assuming it’s not going to zero, MSFT is just a revolving door between buyers and sellers – a **wealth redistribution vehicle** where the only way for prices to rise is for new capital to enter the stock, not by “value creation” by the company. This may seem like a “so what?” observation since outside of bankruptcy scenarios, the market doesn’t “appear” to be a zero sum game. But I think the observation has pretty striking implications. If stocks are really nothing more than wealth redistribution vehicles, then it’s almost a “rigged” game. I don’t mean rigged as in fraudulent, but I do think it’s far from a level playing field if no value is created. How can retail investors possibly compete with hedge fund guys doing this 15 hours a day for years? It’s like a quote I read before – “That’s like a little league team playing against the Yankees – they have no chance of winning.” In other words, on a very basic level, novice investors and vanilla money (like mutual funds) often times are just “giving” their money to smarter investors.
At any rate, I would love to hear how this is wrong if anyone can tell me. Where is JDV? :(
 
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