Is The Stock Market a Zero Sum Game? Exploring Implications for Trading

Is the stock market a zero-sum game? You frequently hear media refer to games and markets as zero-sum games.

Yes, we define the stock market as a zero-sum game, both in the short and in the long term, although it technically is incorrect. A zero-sum game is where one person’s gain is another person’s loss – thus there is no wealth created and the overall benefit is zero. This doesn’t apply to stocks, but it’s a zero-sum game in relation to a benchmark.

Short-term trading in stocks is theoretically not a zero-sum game, and neither is long-term investing. But short-term trading is close to a zero-sum game, and long-term investing is a zero-sum game if we use a broad index as a benchmark. Not all investors can beat the benchmark. Let’s dig a little deeper and explain what we mean.

What is a zero-sum game?

You probably understand by now that a zero-sum game is a game where the sum of the gains and the losses add up to zero. It’s a negative-sum game when the sum of the gains and losses add to less than zero (including commissions and slippage, for example).

Is trading a zero-sum game?

Trading is mostly a zero-sum game: you can’t make a lot of money unless someone else loses. However, in the stock market it might be slightly different, as you’ll understand by reading this article.

Poker is a zero-sum game

Let’s start by looking at poker: Most people can relate to poker and this serves as a great example of a zero-sum game. If there are 10 poker players around a table, no money is being created. The players buy chips and bet their chips and the bets are passed around as you win or lose. Overall, the 10 players as a group make nothing, but player A might win from Player B, etc. Pretty simple. It’s a net zero-sum game: what one player wins the other players must lose (on aggregate). This is exactly how it is in the derivative markets:

Are the derivatives markets a zero-sum market?

The derivatives market is often considered a zero-sum game in the sense that for every winner, there’s a corresponding loser. If you buy an option or a futures contract, there must be a seller on the other side. That seller is either someone selling a long position or someone initiating a short position. The derivatives market is a 100% percent zero-sum game, actually negative if we include slippage and commission. When the S&P 500 futures contract goes up, for example the Globex’ ES contract, what you gain is someone else’s loss.

Because of this, most traders in the derivative markets lose money. CFDs (contracts for difference) are derivatives and let’s look at the stats. What percentage of CFD traders lose money? In a previous article called what percentage of traders fail? we looked at the number of traders making money in CFDs. Brokers are required to reveal this info by the EU regulator. Why they are required to reveal CFDs and not other products, is beyond us. But no matter what, here are the numbers:

• 58% of retail traders lose money when trading CFDs with Interactive Brokers.
• 65% of retail investor accounts lose money when trading CFDs with SaxoBank.
• 67% of retail investor accounts lose money when trading CFDs with eToro.
• 71% of retail CFD accounts lose money with CMC.
• 72% of retail CFD accounts lose money with 500Plus.
• 81% of retail investor accounts lose money when trading spread bets in IG

The numbers vary, and we see that Interactive Brokers (IB) has the best track record, something we believe is no coincidence. IB attracts the “best” and most serious traders – traders that treat it like a business or job. However, it might be incorrect to look at the derivatives market in isolation. Many market participants use derivatives to hedge their positions and that changes things. However, that is outside the scope of this article.

Is the stock market a zero-sum game?

Based on the definition above the stock market can hardly be called a zero-sum game.

Why is that?

Let’s make an example: Let’s assume you manufacture cars. You buy or manufacture components and you assemble the parts into a driving car, and then later you set a price that covers the inputs (parts and labor) and a profit margin. The profit is thus the added value. The added value is reflected in dividends, capital appreciation of the share price, or a mix of both.

For example, Berkshire Hathaway doesn’t pay a dividend but the retained earnings are reinvested into the business, and the shareholders can just sell shares if they need “income”. You have one more argument that this is not a zero-sum game: the Fed (and all global central bankers) keeps on printing more USD.

The stock market goes mostly up, except for a few down years. If you sell shares and realize a profit, it’s not somebody else’s loss. The productivity gains make us increase output and living standards. If someone had to have a loss for someone else’s gain, the stock market would not be able to rise over time. Let’s go to short-term trading in stocks:

Short-term trading and zero-sum game

The markets are intensely competitive and market inefficiencies are hard to find. In the long run, the stock market has risen about 0.05% on any random day over the last three decades, something that is approximately 10% per year. Most of this gain has come from the overnight edge, ie. from the close until the next open. This means it’s very little to be gained in the short-term. If we include slippage and commissions, it gets pretty close to a zero-sum game.

This is why we always label short-term trading as a zero-sum game on this website. Besides, as you’ll learn in the next heading about long-term investing, not all traders can beat the index. If we include trading biases and behavioral mistakes, you become easy prey for the vultures further up the food chain.

Long-term investing and zero-sum game

Before costs, beating the market is a zero-sum game. After costs, it is a loser’s game. – John Bogle

However, we can also argue long-term investing is some kind of zero-sum game if we relate it to an index.

Let’s make an example: Let’s say you have two pools of investors: one passive group and one active group. Everyone who is active, those not indexing, is collectively a big index fund, on average. This group is active and incur both transaction costs and management cost, perhaps a couple of percent is being drained from the pool annually.

The passive group pays much less in costs, thus the active group is at a disadvantage from the start. Those investors competing for “alpha” can’t get it collectively because not all can be winners in this group of active investors.

Thus, long-term investing is a zero-sum game if we compare it to an index. For example, not all investors can beat the S&P 500, that is an impossibility. This is also proven by the fact that most professional money managers fail to beat their benchmarks. That is expected, of course, because as a group not all can get better returns than the index.

There are winners and there are losers compared to the benchmark. If we include management costs, you get many more managers underperforming than outperforming: it’s a negative-sum game. Hence, you practically end up with a negative-sum game in relation to the index.

Is futures trading a zero-sum game?

Yes, futures trading is a zero-sum game for sure. What you gain or lose, someone else must lose or gain. Futures contracts are calculated daily by adding or deducting profits and losses. This applies to all derivatives, also options trading:

Is options trading a zero-sum game?

Yes, options trading is a zero-sum game. If you make a gain, someone else must lose the same amount. When you buy an options contract, a corresponding contract must be issued. This is what is called “open interest” in the derivatives market and applies to futures and options trading.

Zero-sum markets and short-term implications

There is practically only one way to succeed in a zero-sum market: you have to make sure you are not the prey but the predator. The only way to achieve that is by being prepared and always willing to learn and adapt. Make sure you understand the market and its players. Who are the competitors? Who are the predators? What is your trading edge?

Trading and investing: zero-sum game implications

Now that we have defined the different markets and confirmed that the stock market is a zero-sum game, you might wonder what is best for you: Trading or investing – what is best?

Clearly, in the long run, the stock market drifts upwards due to inflation and earnings growth via increased productivity. Even if you don’t manage to beat the index, you are likely to have a positive return unless you invest in completely lousy stocks or mutual funds. Opposite, if you are a short-term trader, you might be able to scale quickly and make lots of money, but you also face a pretty big risk of even losing money.

Is the stock market a zero-sum game? – ending remarks

Now that you know that the stock market is a zero-sum game (depending on a little on the definitions), you might ask yourself: How am I going to be a winner in this market?

Before you start we recommend you spend some time defining your goals and what you are trying to achieve. If you are a long-term investor, are you going to actively pick stocks yourself, or perhaps you are going to invest in actively managed mutual funds, or are you going to invest in passive mutual funds? Or perhaps a mix of two or all three?

At the end of the day, the stock market is a zero-sum game. If you are a short-term trader, how are you going to win against the other players in the market ecology?  

FAQ:

What is a zero-sum game, and how does it relate to the stock market?

A zero-sum game is where one person’s gain is another person’s loss, resulting in no overall wealth creation. While this concept technically applies to the stock market, it’s more accurate in relation to a benchmark. Technically, the stock market is defined as a zero-sum game, both in the short and long term. However, it’s important to note that this definition is somewhat inaccurate when applied strictly to stocks, as it’s more aligned with a benchmark.

How does the derivative market relate to zero-sum games, and why do many traders lose money in derivatives?

The derivative market, including options and futures, is a 100% zero-sum game. When one trader gains, another must lose. This contributes to the fact that a significant percentage of traders in derivatives, such as CFDs, end up losing money. Short-term trading in stocks is theoretically not a zero-sum game, but it is close to one. The markets are intensely competitive, and market inefficiencies are hard to find in the short run, making it challenging to gain an edge.

How does long-term investing relate to zero-sum games, and why is it considered a loser’s game after costs?

Long-term investing can be considered a zero-sum game when compared to an index. After accounting for transaction costs and management fees, it becomes a loser’s game, as not all investors can beat the benchmark, and most professional money managers fail to do so.