In the latest Freakanomics podcast “Stupid things people do with their money” there was this soundbite:
“We don’t understand the negative-sum nature of active investing. Whatever you win, I lose. Whatever I win, you lose, and we both paid to play that game.”
They are talking about investing in the stockmarket and I don’t understand what they are getting at. I myself am an active investor. When one of my stocks increases in price and I sell to realize those profits - who am I hurting? My gain is someone’s loss they say. Who could that person be?
The broker. Every single trade costs you 5 or 10 or 50 dollars that’s why you don’t (or try not to) jump in and out of a stock every day if it’s not moving much and avoid stock brokers that encourage churning to line pockets.
To be clear, they’re talking about active investing, where people make conscious buy-sell decisions in attempts to cash in. I’d need to know more about the context of the discussion and their research and argumentation in its entirety, but it seems like they might be talking about people who trade on a regular basis (maybe day trading?). Anyway, it seems like that they’re just looking at it strictly at the transaction level. If the “loser” stays in the long game and his stocks go up, he doesn’t really lose.
I don’t think you read the question properly. It was “who am I hurting?” I’m pretty sure it’s not the broker, who charges a fee whether you make a profit or a loss.
Here is the transcript immediately following the bit I quoted in the OP:
That’s Ken French.
FRENCH: I am the Roth family distinguished professor of finance at the Tuck School of Business at Dartmouth.
So the negative-sum nature of investing is one problem that’s often overlooked.
FRENCH: And then the second problem we have [is] most people suffer from overconfidence, particularly in noisy environments where the feedback is weak. That describes the stock market. It’s incredibly noisy and it’s really easy to misinterpret what the return on your portfolio means.
The person who originally sold the stock to you has a “loss” in the sense that they didn’t benefit when the stock appreciated.
But he could easily have made a profit, too.
Say he bought the stock at $10/share. He sells it when it’s $15. You buy it at $15 and it goes to $20. He makes a $5/share profit, and you make a $5/share profit. Both of you make a profit. It’s just that he would have made a bigger profit if he had kept the shares until they reached $20.
Now if the stock goes from $20 to $15, the person you sold it to would have a loss. But if it goes from $20 to $25, there’s a profit.
As for the statement, the answer is that the people trading both expect to come out ahead of the deal. And the fact that someone else loses is not a consideration: they’re not out to protect the other person.
Either your stock will continue to go up, or it won’t. If it does, then you’re the loser, because you sold it for a lower price than you could have. If it doesn’t, then the buyer is the loser, because they’ll have paid more for it than they should have.
Note that the stock market as a whole is not zero-sum. It’s only active investing that’s zero-sum (actually, negative, once you include the brokerage fees). Buying stocks and holding on to them long term, while pulling in dividends, is positive.
Oh, OK, thank you to all responses above! So it’s just economists talking nonsense again. Constructing formulas that seek to explain human transactions without accounting for reality. Good job guys.
I sold my stock for a $200 profit. I was happy with that, even when the stock rose higher after I sold it. I am still happy with that. I didn’t lose anything. I gained and was happy to get out when I needed that $200 profit.
I actively invest and I don’t pay brokers fees. All I pay is income tax on profits.
What I say is that the stock market is a fixed-sum game. These can be approached with a perspective similar to that of zero-sum games.
Any sufficiently small subset of traders will have no effect on overall market results — the Dow-Jones will rise 8%, or whatever, regardless of what you do, or of what “your opponent” (for simplicity we can imagine this is a single individual) does.
IOW, if you and the “opponent” both play passively you’ll each make 8%. OTOH, if you make 10% he makes only 6%. And vice versa. Thus, subtracting out the result you’d get passively, the effects of active trading can be viewed as zero-sum. (I ignore broker fees which are fairly small for all but the smallest traders.)
You did, and I get it - but only in the same way that I understand that the sea stays at “sea-level” because there is both evaporation and rain. It’s too complicated to see every move, but a big picture view is also incomplete, and just a guesstimate.
They were phrasing it confusingly. Another post referred to the correct way to look at it but to elaborate: the stock market is (as previously said) a fixed sum game not a zero sum game. Or it’s a zero sum game for various players relative to the gain in the whole market.
The whole market, as defined by a broad index has a certain total return. It’s not zero, could be positive or negative over any given time period but has tended to be distinctively positive over significant time periods. But ‘it is what it is’. If the total return of the index is 10% pa over some long period and some investors/traders by clever trades make more than 10%, some other investors/traders must make the same amount less than 10% on a dollar weighted basis. Everyone put together can’t make more or less trading/investing the index than the index return.
That’s before expenses (commissions, etc) and taxes. The index return is expressed without including those. That’s the negative sum part of active trading on average, relative to the index return.
And these are not hypotheses about market efficiency, they are arithmetic tautologies. Any give investor/trader might have a reasonable basis to believe they will win relative to the index return by active trading before expenses, but they can’t all be right. And after expenses they must on ($ weighted) average be wrong assuming active investing incurs higher costs and taxes than passive, which it almost always does.
To go from Market 101 to Market 102, the equity index futures market is a zero sum game. There’s a long for every short: every $ made by a long or a short must be a loss of the same amount by the other side. Before expenses, negative sum after expenses. So why does it exist? To transfer risk around to whomever is in a better position to take it at a given time. But this isn’t really a different situation than the cash market. Again the cash market is also zero sum for all participants relative to the gain in the underlying market. There’s one market return to parcel out to all the players. More return can’t be created by trading stocks or index futures.
If you buy at $10.00 a share, someone might have bought it at $8.00 a share and their goal was to get out at $10.00 a share. The fact, that you hold and sell at $12.00 a share has no impact on the person who sold it to you.
You aren’t hurting anyone by buying or selling. It isn’t like you forced them to sell is to you at $10.00 a share preventing them from also holding on to it when it reached $12.00 a share.
I think it’s just an attempt at a thought provoking podcast.
My understanding of what they’re saying is as Chronos describes. If you ignore dividends, and just look at the stock as a piece of paper being repeatedly sold, then it’s just a bunch of investors giving each other money, with no new money entering the system. This pool of investors is just moving money around, with a little bit being lost all the time to fees. A bit like a piece of sports memorabilia being resold, or something.
This is separate from holding the stock and collecting dividend income.
I don’t see the nonsense. A buyer and a seller agree on a price. The buyer wouldn’t be selling at that price if he thought the value was going to go higher. The seller wouldn’t be buying at that price if he thought the value wasn’t going to go higher. Obviously, they can’t both be right so one of them is making a mistake.
But traders aren’t just simplistically buying or selling based on “I am selling at the absolute highest price from this point on” or “I am buying at the absolute lowest price from this point on.” They can both be making the right decision based on their own risk tolerance, investment time frame, need for liquidity, trading rules, profit objectives, etc.
Active trading might be a zero sum (negative after commissions) game if (1) only active traders participated in the market and (2) if everyone had to start and end each day (or each week or whatever fixed time period you wish to proclaim) in all cash, so that in order to buy a stock, someone else at some point has to go short.
Otherwise, you can imagine an extreme case as an illustration: Imagine 10 active day traders buy the same stock at the open at the exact same price from long term holders, and then two of those are hyperactive traders who proceed to buy and sell the stock all day long only with each other, with the last trade between them having a price ten dollars higher than the morning purchase price. Then all ten of the active traders sell all of their shares at the end of the day back to new long-term holders at this higher price.
The original sellers in the morning did not lose or gain money; they started with Z dollars of assets at the open and ended with that same amount (less commission). The buyers at the end of the day also did not lose or gain money; they went into the trade just before close with Y dollars of assets and ended with that same amount (less commission). The two hyperactive traders selling only between themselves might be in a situation where one of them is up X dollars minus commission and the other is down X dollars as well as commission (I’m just guessing but intuitively that seems like what would happen), but the other eight active traders are all up 10 dollars for each share they bought in the morning and sold at the end of the day. Also, anyone else who owns that stock and didn’t trade at all that day also is richer by ten dollars per share.
So yeah, in this highly artificial example, for the active trader trading exclusively with another active trader, it is a zero (negative) sum game, but in the real world long-term holders are also buying and selling stock in the market, and it is impossible to say that none of the active traders are trading with them as counterparties, so as a result there can be active traders who are making a profit without a corresponding loss among other active traders or long-term holders.
All they’re saying is that it’s extremely rare that anyone does better than the market. If you attempt to beat the market, you’ll likely end up doing worse than just having an index fund due to fees.