A zero-sum game is when a consequence (either positive or negative) of one party's action is offset by a counter party's consequence. For example, if Jon loses a dollar in a bet to Jim, Jon loses a dollar and Jim gains a dollar. The net result of both actions is zero.
Many people view the financial markets as a zero-sum game, but for traders within the financial markets it is actually a negative-sum game. For retail traders, this means that the odds of winning in the stock market can be low. While there are profitable traders, the profitability of those traders is dependent on a constant flow of losing (or missed profitable) trades by other participants. What many traders and investors fail to realize when they enter the market is that in order to make money someone has to lose money. If there are no losers, there are no winners and the markets cease to function.
In this article we will go over what a negative-sum game is, and also how it can be overcome. Remember, there will always need to be people losing money (or foregoing opportunity to profit) in order for the markets to function, therefore only those that gain a distinct advantage over those that are losing will not join their ranks.
The Negative-Sum Game
A negative-sum game differs from a zero-sum game in that a loss is not directly proportionate to the offsetting gain. In a game where there are limited funds, the pile of funds available to potentially winning participants shrinks. Therefore, new participants need to come into the game bringing in new funds, a few (or one) player end up with the remaining funds, or all participants eventually lose their money.
An example of this is poker, in which the casino takes a "rake" from each pot. If there are five players sitting at a table, and each player puts $20 in the pot, there is $100 in the pot. The first player to play then bets, and all other players' fold, the player who bet wins the pot. If the rake is 5%, the winner of the hand receives $95 for winning the pot, but his is less than what was put into the pot. The winner receives $19 from each player as opposed to receiving the full $20, and he only receives $19 of his own $20 back. This player may also pay a rake on his winning bet. All players may also have to pay a fee for each hour they play.
Therefore, what was bet is not equal to what was won, it is less. In poker, the rake is what makes the game negative-sum; in the financial markets commissions, expenses and fees have this effect. If a trader buys shares from another trader and makes $100 gross profit, the other participant either has lost money or has given up the opportunity to make the profit that the buyer made. The buyer makes $100 - $10 commission, netting her $90. The seller who lost or gave up the opportunity to make money also pays a $10 commission. The net result of these two participants is that $20 is lost to brokers by way of commissions in order for this transaction to take place. (Check out Full Service Brokerage Or DIY? for more.)
It becomes apparent that in order for one to survive in the markets, one must be skilled in the game and new money must continually enter the market if the game is to continue. If no new money enters the market, trades fail to take place and the game breaks down.
Winning in the Negative-Sum Financial Markets
There are several game theory strategies for competing in negative-sum games, yet if we assume that new money will continually enter the market to some degree we only need to be slightly more skilled than the owners of the money who are losing in order to make a profit. There are several strategies that can be utilized in order to be the one(s) who comes out on the winning end of the financial markets.
Make the game as close to zero-sum as possible: We can move the game more to zero sum by not overtrading. By trading too frequently, the commissions will make it very hard to make an overall profit. Since price changes are generally larger over longer time frames than shorter ones, we can take advantage of those price changes by trading less frequently and making commissions a smaller percentage deduction from profits and losses. Only trade when there is a high probability chance of making a profit beyond commissions.
Follow the big money: Following the "big money" means we want to be doing the same things that those who have been successful (thus creating big money) in the markets are doing. What it does not mean is listening to the media. Price and volume are what drive markets, thus pay attention to price and volume as these will provide keys as to where the big money is, and on what side of the market. (For more, see Build A Baby Berkshire.)
- Don't get psychologically involved: The market does provide opportunities for the astute observer to make money when others fail to realize what is actually occurring. Becoming psychologically attached to a position or bias obscures the objectivity that the raw data provides. Traders must be dynamic and be willing to change their positions when situations and indicators show that they should. (Learn more in How To Break Bad Trading Habits.)
A negative-sum game is when the sum of traders' losses and profits is a negative number (this is what goes to the broker and covers other fees). In order to make an overall profit in a negative-sum game we must be more skilled than those that are losing money, and there must also be a constant flow of new money into the market. This is because in order for the markets to operate some traders must lose in order for others to profit. On a personal level we can profit from the financial markets by trading only when the probability of making a profit beyond commissions is high, by following the big money and not getting psychologically involved in trades. (To learn more, check out Paying Your Investment Advisor – Fees Or Commissions?)