I firmly hold that all financial contracts are zero-sum games. Recently, however, I have heard many arguments premised on the idea that the stock market is positive sum because economic growth creates wealth, which is reflected in universally rising stock prices.
But in this scenario, you purchase $1 of stock on Day 1. On Day 100, thanks to robust economic growth, you sell your stock for $100. Are you wealthier? Yes. Has the amount of wealth in the world increased? No. All that’s happened is that someone else has given you $100. Wealth has been transferred but not invented.
In a more general sense: when you buy a stock, you give cash to someone in return for the stock certificate. Later, when you sell the stock, you hand the certificate to someone else in return for their cash. It does not matter whether the amount of cash at the end is more than that at the beginning or less – no cash has been created by this process.
This is not surprising, as it is well known that stock trades in the “secondary market” – which is to say, the market not directly related to the issuing corporation. But even IPO’s do not create wealth – they merely gather cash from many investors who are (suddenly) willing to hand it over to a single company. True, the company may use that cash to generate new wealth – but that is now outside the realm of the stock certificate, which remains a zero sum game in the secondary market.
There is one possible exception. Dividends provide a mechanism by which money is transferred directly from the wealth-generating company to the holder of an otherwise zero-sum game. In other words, an entitiy outside the zero-sum realm is giving money to someone within it – shouldn’t that necessitate dividend-paying stocks as positive sum games? I believe it does not. When dividends are paid, the stock drops in value by the amount of the dividend, ensuring that the holder does not get paid twice for the same dividend. (Incidentally, the same logic led Modigliani and Miller to conclude that dividends are irrelevant in a frictionless world, because any investor can create his own dividends by selling shares of stock). Since the sum of an investor’s cash and the value of a stock he holds is identical immediately before and after the dividend is paid, I conclude that dividends do not create a positive-sum environment.
Thus, stocks do uphold the premise of a zero-sum game: no wealth is created, it is merely transferred. To the extent that wealth is created and injected into the system via dividends, the value of the stock drops by an equal amount, so the net value remains unchanged. The search for positive-sum finance continues…
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You seem to be confusing a stock’s price with its value.
A stock is partial ownership of a company. Thought experiment: Suppose I had bought 100% of Wal-Mart’s stock in 1985 and then sold it in 2000 for 25x profit. Would you say I had participated in a zero-sum game?
Your “dividend” argument provides a nice approach to understanding why you are wrong. If I buy something for $10, and it creates new, real wealth to the tune of thousands of dollars for the rest of my life, that is obviously not zero-sum! Your invocation of Modigliani-Miller demonstrates not that dividends are zero-sum, but rather that stocks themselves are not zero-sum, even those that never pay dividends.
Owning a wealth-creating asset is different than making a bet.
On the contrary, it absolutely is a zero sum game.
Zero-sum only means that the system is closed – it does not prohibit you from making a 25x profit. Remember, we are only concerned with cashflows, so price and value are fungible and essentially irrelevant, especially with regard to the underlying company. If you purchase all of WMT’s stock, and then Wal-Mart generates millions of dollars which is in turn used to repurchase your stock at a massive profit, then your stock has not generated wealth, Wal-Mart has. And that wealth doesn’t enter the zero-sum game as it relates to your physical shares until you transact them, at which time you take the money from someone else – thus, your shares did not create wealth, they merely allowed its transfer between you and another party, which is a zero-sum game (the fact that Wal-Mart generated that wealth is irrelevant as far as your specific stock certificates are concerned).
Many people agree that derivatives are zero-sum, so just think of stock as a derivative of the firm value. In fact, replace “stock” in your example with “call option” instead – you purchase an option directly from WMT on 100% of their shares in 1985, and years later it has gained massively in value. Someone buys it from you at a profit. Certainly that is a zero sum game; and stock is no different.
The key here is that the wealth “created” by selling stock is really just cash transfered to you from other people. It may be more than you started with, but just the same, it’s someone else’s dollars which you now possess. And every dividend dollar you receive is exactly offset by the loss of one dollar of stock, so you don’t really create wealth that way either. Again, if it helps think of stock as a fixed income derivative of future cashflows (sort of a Gordon Growth Model, it’s just the present value of the future dividends) – its zero sum nature may be clearer that way.
Well, you could argue that all transactions are “zero-sum” except when money itself is literally created. After all, any money you ever receive must come from somewhere.
But this is not a particularly useful or natural definition. For example, if I buy a business from you for $1 million, and then it earns a profit of $100k (which I pocket), and then you buy the business back from me for $1 million, it is absurd (in my view) to consider this “zero-sum”. You ended up where you started; I ended up $100,000 richer; ergo, this is “positive-sum”.
Your call option example is completely different because of what happens on the other side of the trade. If I buy Wal-Mart stock and later sell it for a huge profit, I receive money, but the buyer receives my stock, which has real value. That lone transaction itself is zero-sum, because the stock is worth what I sell it for (more or less). But the total, if you include my original purchase, is positive-sum, because Wal-Mart stock increased in value, not just price, over those 15 years. On the other hand, if I used a call option, the value of that option would be positive to me and negative to somebody else. When I exercised it, that person would replace his negative-value option with a hole in his balance sheet (net change: zero), while I would replace my option with stock (net change: also zero). The total value between us would be zero from the day we entered the contract until the day I exercised it.
“Zero-sum game” means that for every winner there has to be a loser. This is simply not true for stocks because they are ownership in real businesses creating real wealth. My stocks can increase in value without anybody else in the stock market losing anything. Ergo, the stock market as a whole is not zero-sum. (Unless the businesses within it are themselves creating net wealth of zero.)
Of course, I am assuming that there is such a thing as “wealth” that is not the same as “money”. Do you disagree? If so, then we have nothing more to discuss, because we disagree on axioms.
I think you’re right – our disagreement comes because I don’t differentiate between “wealth” and “money”, “value” or “price” – a company’s market cap or market value is just the amount someone will pay for its equity. The exchange of an asset – stock, option, or otherwise – is perfectly compensated by the transfer of cash, and wealth at the time of the transaction is preserved.
My other point, which is arguably semantic, is that a zero sum game does not necessitate an immediate or apparent loser for every winner; it just means that wealth is transferred from one investor’s account to another’s without being invented in the interim. In the end, the two definitions may net out, but if I buy and sell a rising stock to you and you do the same, then it’s more difficult to see where I gained and you lost per se.
In the company example, we must distinguish if the $100k profit is paid by the company or as a dividend on stock. If the former, then the company must be included in the transaction ledger: $100k to you, -$100k to the company, and the third investor is flat, for a net zero sum transfer. If the latter, consider the transaction in three steps (my numbers are arbitrary): in the first, I buy stock for $1m, and it appreciates to $1.2m. This is zero sum a) because the gain is unrealized and b) if I decided to realize the gain, my profit would be paid directly from another investor’s cash balance. Next, I receive $100k in dividends, and my stock immediately drops to $1.1m to offset. Thus, I am no wealthier than before the dividend, except that my cash/stock allocation has changed (hence MM indifference). Finally, the stock depreciates back to $1m and I realize my profit by selling it to another investor, who compensates me directly with funds from his account – a zero sum transfer. The net of these three zero sums is itself a zero sum.
I understand why you find my definition too broad, but it’s the same reason I like it – any finite resource should be a zero sum game; true wealth creation (as opposed to convincing consumers to give you more money than it cost to produce something) is rather difficult indeed.
Nemo
If I sell you an option to buy my business today and buy an option from you to buy it back at the same price in one year is that two zero sum contracts?
Does it matter if the option is exercised?
OK, I lied. I will make one quick effort to try to convince you to re-examine your axioms. (And the more I think about it, the more I think stocks are not zero-sum even if you conflate money with wealth.)
Your argument reduces to a tautology: Every transaction transfers something between parties; therefore, every transaction is zero-sum; therefore, every collection of transactions is zero-sum; therefore, “all human activity is zero-sum”. Which may be true under your tautological definition, but it is hardly useful (and barely even meaningful).
I would also say it is empirically false, because there is such a thing as wealth creation, and it happens all the time. Although it is not performed by anybody working in finance, which may explain… Oh, never mind.
Now, in any given system of transactions (“game”) — e.g., the stock market — either new wealth is entering or it is not. If new wealth is not entering, then the total gains for the game’s winners must equal the total losses for its losers, and the game is zero-sum. This is true for the options market, for example, where the total value of all options everywhere is always precisely zero.
In the stock market “game”, new, real wealth is entering, in the form of profits on which the stocks represent an actual claim. (Or, if you prefer, in the form of new money which people are willing to exchange for those claims on profits.) If you add up the value of all long and short stock positions everywhere — even using your assumption that “value” is “market value” — the total is not zero and it is generally growing. Although not so much over the past decade. But whether growing or shrinking, it is not zero-sum.
Sure, you can define “wealth” as “energy” and then conclude the entire universe is “zero-sum”. But this is not what anybody else means when they say “zero-sum”.
By the way, thank you for the interesting discussion. The best way to think something through is to debate it with someone smart, and this is the first time I have really thought this through.
It’s interesting – when I was writing my response, I wondered if I hadn’t bit off more than I can chew: does my definition really require the world to be zero sum? After all, every transaction by definition must be funded with cash that existed before the transaction, so there seems to be no room in my theory for any wealth creation.
I am still not convinced that this is a wrong or bad conclusion – for example, gentle upward growth of the entire stock market could easily be funded (in a zero sum sense) by a few stocks going to zero each year; and what is the role of a business except to receive funds from consumers (creating wealth for the managers, but at the expense of those consumers). Ultimately, the only real wealth creation would lie in the hands of governments and banks, who have the ability to expand and constrict the amount of wealth available in a very real way. Indeed, fractional banking “creates wealth” in the sense that a dollar deposited can fund much more than just one dollar of future spending. This doesn’t require loss at the expense of gains, however (I can feel the “but then developing nations are doomed without first world sacrifice!” crowd closing in), because even a fixed amount of monetary wealth can be exchanged for a constantly improved lifestyle and environment.
For example, when I buy an iPhone, I feel like I got the better of the deal – only $200 for this life-changing device! I feel wealthier although the amount of money in question hasn’t changed: my $200 is now Steve Job’s $200. But I have an iPhone – which only cost $160 to manufacture. So I suppose $40 of abstract value lives in my phone. And that, I think, is the Great Deception of this worldview: any wealth creation is borne of technology and ingenuity, supplying an ever-more comfortable (and hence higher-utility) lifestyle for an ever-decreasing price. It doesn’t matter that the cashflows net out, because the pleasure received in exchange for those cashflows is continuously growing. Next year, I’ll give Apple another $200 for another iPhone, and they will pass that cash on to their suppliers, and thanks to advances in technology it will all be put to better and more productive use – thereby increasing wealth despite a constant amount of money.
So, I do see that point of view now.
But I’m not quite ready to abandon my belief that the derivative contract or stock (which explicitly lacks the abstract wealth I was describing) falls under that umbrella, since I even see common stock as an ultimately unproductive device on par with cash itself. It’s just an efficient store of monetary value. The goal of capitalist markets is the efficient allocation of resources, and zero-sum would epitomize that optimization problem by prohibiting the “deus ex” introduction of new capital, requiring instead that existing capital be redistributed to its most effective location.
So I’m afraid you’ll have to forgive me for being a stick in the mud – it’s not that I don’t follow your argument, I’m just coming from a rather different direction. In fact, most people I’ve spoken to would agree with you. I’ll even go so far as to say that with more reflection I will too, but for the moment (and the foreseeable future) I’m not quite ready to concede.
And thank you also for taking the time to go back and forth – the web has become such a one-sided shouting match and it’s a pleasure to be able to civilly discuss both sides of an idea.
Well, now I want to try to convince you that money is not really wealth.
Suppose you are a skilled carpenter who knows nothing about painting. Suppose I am a skilled painter who knows nothing about carpentry. Suppose we live next door to each other, and your house needs a paint job, and my front porch needs to be repaired.
Now, you could just paint your own house, but that would be hard, because you are not a painter. (And the result might not be pretty.) I could repair my own porch, but that also would be hard because I am not a carpenter. (And the result might not be pretty.)
So we trade. I paint your house, and you repair my porch. What just happened?
I did an easy job (painting), but got to enjoy the result of a difficult job (carpentry). You did an easy job (carpentry), but got to enjoy the result of a difficult job (painting). In a very real and literal sense, we both came out ahead; we each exchanged a small amount of labor for a large amount of wealth.
These concepts of labor, wealth, and trade are more fundamental than money. Money merely represents wealth. In fact, the only reason money exists at all is to facilitate this sort of trade. (Bartering works for neighbors but not so well for neighborhoods, and not at all for nations.)
Your intuition about the iPhone — “this life changing device only cost $200!” — is getting at the same idea. It is intuitive and natural because it is correct.
Well, in my opinion.
You don’t have to convince me – of course money is the fungible asset that keeps us above a barter system. In fact, there is no reason a bartering example such as the paint/carpentry one couldn’t be enhanced with each person paying the other for his services in cash; at the Pareto-efficient level, no cash would be exchanged and at any other level, a small payment would be made from one person to the other. In this way, wealth is quantified.
But in financial contracts, cash is unequivocably the only means of settlement and there is no place for comparative advantages. The system surrounding the contract is closed except for the cash already inside it, which therefore – in this situation – fully represents the wealth under consideration.