Word of the Day – Zero Sum Game

A situation in which one person or group can win something only by causing another person or group to lose it. (Source: Mirriam Webster Dictionary

The definition of this economics term is simple, but spotting the reality of being in such a game is not so easy.

We’ve all seen shell games. If not in person – on TVs or movies. 

In these games, watchers are invited to bet on whether they can see where the con man places a ball under three containers he is shuffling around. 

The financial markets essentially do the same thing. We are invited to bet that we (or someone we pay who we think is smarter than we are) can predict where some kind of investment is going to land by a stipulated amount of time.  

The probability of any random event, e.g. rain on any particular day is actually 50/50 over the long run 

We know this from the law of large numbers used in statistics – where a coin is tossed Ad infinitum, the results ultimately move towards 50/50 heads/tails.

But of course, on some days it is easy for us to see that rain is more likely than not and vice versa. 

So we bet on stocks (or futures contracts or commodities or currencies, etc.) within short periods of time where the law of averages (i.e. large numbers) does not yet make the odds 50/50

After the end of each time period we choose, (a minute, hour, day, week, month, etc.) the result is always a zero sum game. The total payout for bets is zero. The winners cancel out the losers.

There may be differing amounts of winners or losers in each time period (i.e. higher or lower volume of bets) but the total amount of money they all bet will sum up to zero.

Winners win at the expense of the losers. Winners (including the Brokerages who take out their cut first) are not necessarily those who will have better knowledge of factors affecting the bets they make. They may just be lucky. But losers are those who, by definition, make poorer choices.

And this is where our brains trick us. On bets that we win, we feel pleasure, intense pleasure. On bets that we lose we feel pain, intense pain. We hate to lose and we love to win. 

For some of us, loss aversion gets in the way of ever winning. It even prevents many from playing the game. For others over-confidence gets in their way. Or being given an  overwhelming amount of choices to make.

One must be prepared to lose in a zero-sum game. To stay in the game one must calculate as best as one can how to offset losses with a win that at least hits a breakeven point. This takes some patience, comfort with arithmetic, and skill. 

Corollary terms to zero sum games are: win-win / win-lose/ lose-lose situations.

If we want to be in a win-win situation, we should probably go outside of the markets to a place where we are not relying on someone else to lose so we can gain. 

You might object that Warren Buffett got rich in stocks, so why not us? But this would not be the whole story.

Warren Buffet and others like him have become wealthy because they created or bought companies that were doing great things, things that were a win-win, both for other people as well as themselves. 

In particular, Warren Buffett started out by buying insurance companies. He used insurance company’s  money to buy other companies who were doing things of value.

Warren saw that insurance companies had piles of money on hand that insured people expected their heirs to collect when they died. This was money Buffett could use to make more money until those insured people died.

This use of money to make more money is how insurance companies can afford to pay their policy holders dividends or interest each year, money that is not even taxable by the federal government. 

But not all money is equal. Money that is not taxed is valued higher than other money. Some money has value because it can help produce things of value. Other money is worthless because it goes “poof” when the going gets rough. It takes a dedicated person to separate the wheat from the chaff. Money games are hard to win.