DO/DID YOU KNOW?

The Zero-Sum Game

In our Do or Did You Know? blogs we provide readers with useful information that generally is not realized by inexperienced investors. In Chapter 5 of our publication, When to Buy and When to Sell: Combining Easy Indicators, Charts, and Financial Astrology (available on Amazon), we introduce the concept that stock prices are a “Zero-Sum Game.”   

     The official definition of Zero Sum is the situation in which the total gains and losses are equal among participants of a financial transaction or trade, or to simplify, one’s person’s gain is another one’s loss. 

     Though there are several types of examples of zero-sum thinking, we focus only on the financial aspect. An example of this concept in the business world would be an owner/entrepreneur who perceives that his own success is only possible from competitors failing, rather than recognizing that similar business’ success can create value and expand demand for the service or product.  

     In the investment world, every stock, equity, and/or asset has a specific value “frozen” in time. Whether the instrument is a stock, piece of real estate, or personal item, there is both a “real” and “perceived” value at any given moment.  

     The perceived value, of course, is the expected return on an investment (ROI) when one chooses to sell. At the moment of purchase, the investor had an expectation based on factors including knowledge of the product, an expected appreciation of the asset, or simply “hoping” it would be worth more than when they bought it. There are certain beliefs that items including real estate, successful businesses, and collector’s items/relics always “go up,” based on history, location, and an array of formulas. 

     When considering the purchase of a stock, and some other physical assets (like precious metals and fine art), the investor usually studies factors like fundamentals, economic conditions, supply and demand, scarcity, industries, and new technology. Indexes like the S&P 500, Dow Jones, and even the Nasdaq (technology heavy) tend to rise over time, which is popular with longer-term investors.   

     “Value” investors commonly use financial indicators such as Price to Earnings Ratios (P/E), sales figures, historical price action, and many more fundamentals, to determine the current “fair” cost of an asset, to determine if it “should” be worth more in the future. Some even take the approach of purchasing when prices fall, known “buying the dip.” Only experienced individuals should employ this tactic, as no one knows when the decline will stop.  

      Swing and Day traders generally study technical charts, the news, earnings, and other factors, to again determine the current short-term, or immediate, “value,” while attempting to gain an edge and make a profitable trade. 

      Options traders can face situations where they were correct about the future direction of price, but still “lose” due to time decay. 

      The truth is, though all these approaches have some validity and may be successful tactics, the price of any asset, at any moment in time, is worth exactly what it can be sold for at that time. That is the zero-sum concept in a nutshell. If Buyer 1 purchases at price A, and they are correct about the perceived price in the future, they “win.” If the price is lower in the future, for any reason, they “lose,” if they sell. They may also “lose,” technically, if the price continues to rise after they sell. Price A is the “base” from which they are working, and price B is the figure they sell, or determine as the current market value. Buyer 2 then starts the cycle all over again with a new purchase price, and may also “win” or “lose.”  

      As far as stocks are concerned, prices are very fluid, due to traders, algorithms, and markets open 24/7 all over the world, and often quick decisions must be made. Be extra cautious with high flying equities with sharp upturns, as they are vulnerable to profit taking and just as quick retracements. Potential short-term popularity (fads), and potential “pump and dump” schemes need to be recognized, and avoided as well, as they are designed to pull in overzealous investors. If one chooses to invest in an unproven market, it is advisable to keep your position size/amount invested small, with funds that are disposable.

       So, to review, it is very important to use sound judgment and analytical data to determine the “perceived” future value of any investment. A purchase should not be based on your “favorite” player (for a sports collectible) or your “dream” house (for real estate), and certainly not from an inexperienced source when it comes to a hot penny stock. All types of investors can make or lose money, and it is important to “let go” of small losers quickly, before they become BIG losers. Don’t let hurt feelings or the acceptance of a bad judgment make a bad situation worse. The more you understand yourself, the more you can adjust for success. 

      Remember, the price of any asset “is what it is” at any moment in time.

*** This information is not intended to be financial advice, and should be considered or any specific buy or sell recommendation, but rather a guide to assist the reader in some further understanding of the financial markets.