The market doesn't create value. It reflects it.

“The stock market creates wealth.” This is obviously false. Unlike Social Security, no dollar ever comes out of the market into an investor’s pocket that didn’t go into the market from another investor’s pocket…

This is true, but not in the sense that the author seems to intend it. The market doesn’t create value. It reflects it. But sure you can make money in the stock market.

It seems to me that it should be intuitively obvious that the stock market is a zero-sum game, but I guess some people don’t think so. Maybe they don’t understand what a zero-sum game is. Or maybe they have some other reason for wanting to believe that the market magically creates wealth.

This just happens to be completely wrong, for reasons I will describe.

If we take a market as a “blob” then, yes, the blob creates value. If you break down markets into their functional parts, then trades are zero sum: the cook got a dollar’s worth of carrots and the farmer got a dollar’s worth of money. That both valued the outcome as positive is a given as otherwise the trade would not have happened. Seen in that light the trade was a win-win transaction but we have no way of measuring either win without knowing the previous pre-trade state. To me one thing becomes clear, that value is created between trades and realized by the trade.

I’m trying to discover why and how markets work. Markets don’t grind out value like a factory grinds out sausages. Markets grind out trades. Where then does value come? It’s an emergent property of markets. By being able to trade something less useful for something more useful at par, both sides have gained in value. But it wasn’t the trade that created the value, the trade only realized the value.

Denny has the germ of it here, but the gain value reflected in the stock market can’t be described with money paid for carrots. Think of it this way. You are buying a piece of a company. Okay, say I bought the share in the company from Mr. Smith for $50. He bought it a year ago from someone else for $25 dollars. The company did well and grew and made money and built more factories, etc. That’s why the share, which had been worth $25, was now worth $50. However, all the market did was reflect that change in value when Mr. Smith sold the share to me for $50. There was no corresponding loser of the $25 he gained. It was NOT a zero-sum game in any sense. The market has simply reflected the progress of the company. It didn’t make the wealth. It’s simply the place where I could buy a share of the company. It’s just the mechanism that allowed me, who wanted a share in this company, to find Mr. Smith who wanted to sell a share of the company… because he wanted to buy a pair of Skechers.
:wink:

Now I’ve held the stock for a year or so and the company has continued to grow so my one share has grown in value to $100. (The market has again reflected the progress of the company). I decide to sell my share to Mr. Jones for $100. I gained $50. No one lost $50. Mr. Smith didn’t lose anything; he’s long gone. Mr. Jones didn’t lose anything. He just wandered on the scene. In fact he just heard about the company yesterday. This is not a zero-sum game like a futures contract or option contract that will expire and whatever one party gains some other party will lose. This has simply nothing to do with the concept of a zero-sum game.

And if the company prospers and its share increases in value and Mr. Jones sells it for $175 in a year or so, and makes $75, he gains that $75. There is no loser. I didn’t lose anything, the person who bought it from him didn’t lose anything. He simply gained $75. But the market didn’t create the $75. It’s just the mechanism that allowed Mr. Jones to find a buyer for his share.

I hope this helps.

Saul

PS If you want to think of it in farmer terms, I bought a spindly-legged little colt for $50. It ate a lot of grass and grew into a big strong valuable horse worth $250. I took it to the Saturday market in town and sold my piece of property, which had appreciated in value, for $250. I made $200 profit. I didn’t even pay for the grass. There was no loser. It had nothing to do with a zero-sum game when you understand what a zero-sum game is. The Saturday market (stock market) didn’t create any wealth. It was simply where I sold my horse. Period.

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Saul,
I admire your persistence. Nevertheless, I’d wager (zero sum) that there will still be folks who insist that the stock market is a zero sum game.

If we concede that the stock market transaction is zero sum, I think we would then be hard pressed to identify any transaction that is not zero sum. In every trade (cash free barters included) there is an exchange where each party gives up something of value in return for something of perceived equal or greater value. In fact all participants in the trade (assuming it was free from duress or other extenuating circumstances) are in the same position, if not they would not participate. Hence all transactions are zero sum.

I excluded transactions which were not freely undertaken, for example paying a ransom in order to free a kidnapped loved one. Is it really any different? Is there not an option? One could respond, “Yes, I love my (insert relationship) but not that much. He/she’s yours. Put me on your do-not-call list.”

Refused zero sum transaction?

“Okay, say I bought the share in the company from Mr. Smith for $50. He bought it a year ago from someone else for $25 dollars. The company did well and grew and made money and built more factories, etc. That’s why the share, which had been worth $25, was now worth $50. However, all the market did was reflect that change in value when Mr. Smith sold the share to me for $50. There was no corresponding loser of the $25 he gained. It was NOT a zero-sum game in any sense. The market has simply reflected the progress of the company.”

Actually the difference between the $25 and $50 price is the aggregate of every trade that happened between when Mr’ Smith bought and sold his share. Every one of those transactions in that timeframe has a winner and a loser, either realized or on paper, so you do have a temporary zero sum game here.

Now, companies can and do grow and create value. Whether this value gets offset somewhere else is for some academic economist to debate because it’s not really relevant to the matter at hand. You can ride the wave of the company’s value creation through investment in a security, but the price only changes when buyers and sellers agree the value is somewhere else than where it is. And it’s quite likely that during anyone’s holding period, their transaction in a security does represent a zero sum game in the market.

Really I don’t think it matter either way with regard to investing, but I do think saying something is a zero sum game or not is a poor argument for saying stocks are better than options or futures or anything else. All are just instruments to participate in the expected growth and value creation of a company/industry/region/market/commodity or whatever you choose to allocate capital to.
And the price buyers and sellers agree on determines what value you get for that capital at any given time.

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Saul,

I see what you are saying, but still am not convinced that the market is anything but a zero sum game, albeit a very complicated and long term game. While your example shows how a string of stock purchases can be profitable for all involved, it is only a very very small bit of an overall market’s transactions. I contend that the only way that a stock market value can grow is via IPO’s, where private companies are purchased with new money and thus become part of the market. This is akin to bringing new players into a poker game. In all other situations there are always two sides to the transaction, money in, money out, so they must always be equivalent by definition (neglecting brokers fees for simplicity).

I really like your horse analogy, but would present it in another way. In my example horse owners are not allowed to actually buy a horse in the normal way. If they do, they have a private horse, and that person(s) alone control the situation, and either reap the reward if the horse wins the triple crown or lose money if he breaks a leg and must be put down. The stock market is more akin to a group of horse folk who want to race horses, but can’t afford it. So the farmer makes them a deal. I will sell you guys my horse, splitting the cost into tenths (for 10 “investors”) and you’ll each be 1/10 owners going forward (an IPO). I’ll pay for everything using your money – train the horse, enter it in races, etc., and keep any winnings, stud fees and such under the umbrella of our group. Of course the farmer will draw a salary for his efforts from the group funds, and he may even choose to put in some of his own money to buy shares. Further, the horse owners in the group are free to sell their interest in the horse at any time to anyone of their choosing, and if the horse has been successful, the seller might make a profit on his share. But for every transaction, there is equal money in, equal money out. The buyer pays the money, and the seller takes the money. Zero sum. The only other way that any owner of this horse can realize their good fortune is to liquidate by selling the horse group, taking it back to being a private horse. Of course there is also the risk that the horse will stumble out of the gate, break a leg, and poof! there goes the group funds.

Thinking about it there is another possible scenario in zero-sum horse ownership. What if the farmer agrees to pay out race winnings as-you-go? So if the winner’s share is $100,000 everyone in the group gets 10 grand (like a dividend). Sweet. If you only paid $5,000 for the initial share, you are indeed a winner, and this seems to be outside the zero-sum definition. Of course you could argue that by taking the $100,000 out you have diminished the “value” of the share ownership by exactly the same amount, so is still net zero. Particularly if by draining the cash supply, the horse can’t be trained properly anymore. But I think that even with dividends, the net effect is zero sum. Still pondering dividends though…….

Just my two cents,
DT

The market is not a closed system. There is energy being added into the economy. The energy that is added into the system primarily stems from the sun’s past energy (converted by photosynthesis to produce more complex carbon chains which have potential energy). This energy is used to fuel the work needed for most things on our planet. Some of this work gets applied to making people and food, and also for building companies which make all kinds of products and services. Since there is such a huge quantity of energy being applied to the system, the system must increase its energy storage, provided that more energy is inserted than is lost out of the system. I don’t not think that our planet is losing more energy to dissipated heat than it is taking in.

The market is a collection of companies that is taking in energy to do work. This collective work is adding value into the system. The collective value of these companies is constantly increasing so investing in companies cannot be a zero sum game. For it to be a zero sum game, the value of all the companies that are traded on the stock markets could not be collectively increasing in value. Since this is not happening, the market cannot be a zero sum game.

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Hi DT, the key is that what makes the value grow has nothing to do with the “market” or the “Market”. It is the growth in the value of the underlying company, that the stock stands for and is a piece of, which is real growth, and really creates real value. The market is just the place we meet to exchange ownership in the company (if we choose to).

Saul

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What’s the purpose of actually deciding whether the stock market is a zero sum game or not? Unless those of us on the board are the only ones playing, does it matter? Presumably, any time anyone buys or sells a stock one is expecting that he or she is taking advantage of the other side (by buying an undervalued stock or selling an overvalued one).

From what I can tell most of the arguments differ based on the scope of consideration. What’s considered the market? For one transaction, it’s zero sum (amongst the buyer, seller, and the brokerages taking the commission). Over a decade or two, depending on the macroeconomic arguments and monetary policy, I just don’t know. For all of time, I guess it could be considered zero sum because humanity started out with nothing and in the end will be reduced to nothing. Or is it infinite sum, since entropy always increases?

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Saul,

You are absolutely correct in your observation that the stock market is NOT a zero-sum-game, but I doubt you will get an agreement and that is fine.
The only Zero-Sum Market out there, is the FUTURES market.
I traded Energy futures for over 20 years and believe me, for every winner there is a looser, but not in stocks.
Erk

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A zero-sum game only occurs when somebody gains something that is exactly proportional to someone else’s loss. Money being traded for carrots is not a zero-sum game, it’s just a transaction. The only way that becomes zero-sum game is if we’re talking about a finite amount of carrots in the world that can never be grown again. From wikipedia:

Many economic situations are not zero-sum, since valuable goods and services can be created, destroyed, or badly allocated in a number of ways, and any of these will create a net gain or loss of utility to numerous stakeholders. Specifically, all trade is by definition positive sum, because when two parties agree to an exchange each party must consider the goods it is receiving to be more valuable than the goods it is delivering. In fact, all economic exchanges must benefit both parties to the point that each party can overcome its transaction costs, or the transaction would simply not take place

The market is not a zero-sum game. There is no proportional loss for every gain. The population is consistently making more money over time and adding to the market. Companies are creating value through dividends and share buy-backs.

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You are absolutely correct in your observation that the stock market is NOT a zero-sum-game, but I doubt you will get an agreement…The only Zero-Sum Market out there, is the FUTURES market. I traded Energy futures for over 20 years and believe me, for every winner there is a loser, but not in stocks.

Thanks Erk, I’ve tried and tried to explain what the concept of zero-sum game is, even with the dictionary definition, but I’ve given up.
Best,
Saul

A zero-sum game only occurs when somebody gains something that is exactly proportional to someone else’s loss. Money being traded for carrots is not a zero-sum game, it’s just a transaction.

Thanks to you too, eddie. I’d just change what you wrote to

A zero-sum game only occurs when somebody gains something that is exactly equal to someone else’s loss.

Best
Saul

Here’s an example why the market is not zero-sum. Suppose there are 100 shareholders of XYZ stock that is currently valued at $100 (market cap of $10,000). XYZ suddenly gets chosen as a supplier for a major company’s newest project. The 100 shareholders are happy, but in no rush to sell their shares as they believe more good news is on the way. People without shares, however, are begging for a piece of this company and keep offering more money for these shares. Finally, 1 out of the 100 agrees to sell their shares at a sale price of $150. This transaction determines the new market price of $150. So now there are 100 shareholders at a market value of $150 for a total market cap of $15,000, but only one transaction has occurred? Where did this new $5k come from? And if it is zero-sum, who lost $5k to equal out the gain?

Obviously the market is much more complex, but it is in no way zero-sum.

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I’ve tried and tried to explain what the concept of zero-sum game is, even with the dictionary definition, but I’ve given up.

This is what I mean by deferring to authority (of the dictionary in this case). :wink:

A basic premise of science is that theories are falsifiable. Believing something because a book says so is bad science. When we are talking markets we are talking about a science, economics. I’ve found the discussion quite fascinating.

Denny Schlesinger

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After reading this thread several times I wonder if what the disagreement might be based on is a difference in terms. That is some may be using equilibrium as a substitute for zero sum.
The market is always in equilibrium, at any given moment, some hold all the cash and some hold all the securities and no matter how many trades are done the monetary base is the same and the number of shares are the same. That is equilibrium. But as wealth is created equilibrium must be reestablished, one of the reasons the monetary base must go up. As we all learned in Econ 101 money is a store of value and a medium of exchange. Simply put, if you create more wealth you have to have more cash to facilitate the storage and exchanges or this new wealth. Get that wrong and you get inflation or disinflation etc. and since none of the last three Fed Chairs ever listened to any of my many emails they never get it exactly right, but you get the point. Wealth is clearly being created and it is reflected in the market over time, some win and some lose, but if the economy is growing in real terms there must be more winning than losing so it is not a zero sum game, but it is in equilibrium.
Just my two cents
Mike

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This transaction determines the new market price of $150.

Correct! But please note that this is exchange value (mark to market). Saul’s explanation depends on intrinsic value. He wrote:

Think of it this way. You are buying a piece of a company. Okay, say I bought the share in the company from Mr. Smith for $50. He bought it a year ago from someone else for $25 dollars. The company did well and grew and made money and built more factories, etc. That’s why the share, which had been worth $25, was now worth $50. [emphasis in the original]

Ben Graham reconciled the two views by stating that in the short term the market is a voting machine (mark to market) but in the long run it’s a weighing machine (intrinsic value). For Saul’s view to hold the market would need to be perfectly efficient, which it isn’t. But his view certainly agrees with Graham’s long term view.

BTW, zero sum games can be played by more than two players. It’s zero sum because the gains add up exactly to the loses. A friendly game of poker is a good example.

Denny Schlesinger

It’s zero sum because the gains add up exactly to the loses. A friendly game of poker is a good example.

Of course it is!

Denny, you knew all along what a zero-sum game was!!! So why were you hassling me so much? Just wondering.

Okay, usually I wouldn’t get into this discussion because it is impossible to change people’s minds when they don’t want to be changed. But in this case I am because it is important. The difference between the two sides of this argument is the difference between investors and gamblers or traders. If you are hoping that you are just buying low and selling high because the supply and demand is driving the price up. Then you are a trader and you can think of it as a zero sum game.

But if you think of it as buying a company, it definitely is not a zero sum game. The reason it feels like it is has to do with the frequency of trading. When one person buys and sells the transaction is zero sum. There is a buyer and seller. The non zero part comes from the increase in value over time.

The reason this is important is that if you believe it is zero sum, you trade. If not, you invest. I love Warren Buffets example. Buy companies you want to own if they shut the market down for ten years and cannot trade. This shows the value creation. There are no trades for ten years but then the company is either worth more or less but it is not zero sum. Chipotle builds a store and 18 months later has all of its costs out and still owns the store. That is value creation.

I believe in value creation or I wouldn’t be investing in the stock market. I am not trying to outrade the next guy, I am trying to own a business that is growing and creating value.

Randy
Long CMG.

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Denny, you knew all along what a zero-sum game was!!! So why were you hassling me so much? Just wondering.

I wasn’t hassling you, certainly not intentionally. I might have misspoken and if I did would you kindly point it out?

Someone mentioned “scope” as the key to the disagreement and I concur. It depends on what you consider “the market.” If I remember correctly I started out taking about markets in general but the replies focused on one specific market, the stock market, which is much more complicated than, say, a produce market. A produce market trades in real property. The stock market trades pieces of paper which represent real property. A funny thing occurs, by trading the paper instead of the real property, the pieces of paper acquire a life of their own. A perfectly steady business can develop stock bubbles and busts and the price of the stock becomes disconnected from the value of the real property.

When I was talking carrots I was talking about markets that trade in real property, not paper. No wonder there is so much confusion.

Denny Schlesinger

For Saul’s view to hold the market would need to be perfectly efficient, which it isn’t.

Not at all. For the sake of the example, a specific transaction was referenced to illustrate the change. But, the example carries the same conclusion if there are thousands of transactions over a year which contribute to setting the new price.

The core issue here is that a single transaction taken in isolation is necessarily zero sum, but the long term impact of transactions on the holdings of those participating in the market is not zero sum … exactly because changes in price produce changes in value for those not participating in the transactions.

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The core issue here is that a single transaction taken in isolation is necessarily zero sum, but the long term impact of transactions on the holdings of those participating in the market is not zero sum

Sum a string of zeros and you don’t get zero. New math?

Denny Schlesinger