We’ve been building a series on finance here, and we’re not even at basecamp level just yet in terms of our ascent on Mount Finance. But I just realized that while I’ve started the series, I have not laid out two ideas that I think are central to thinking about finance. One idea for today, and the other for tomorrow.
Today’s idea is about zero sum games.
I’m big on non-zero sum games. Students at GIPE are probably sick and tired of hearing me uttering the phrase now, but it’s never going to stop. The world is where it is today precisely because of the fact that it is a non-zero sum game, and most of our problems in life and society would go away if only we understood and applied the principle in all walks of life. But that’s a separate post, and I’ll get to it one day.
For those of you who are unfamiliar with the concept, a trade in which both parties are left better off than they were before is called a non-zero sum game. Also called a double thank you moment, by the way.
Here’s the thing about finance.
For me to win, you have to lose. There’s debate about whether this is true for all of finance or only a part of it, but options theory in particular is (at least in my view) definitely a zero sum game.
Options and futures trading is the closest practical example to a zero-sum game scenario because the contracts are agreements between two parties, and, if one person loses, then the other party gains. While this is a very simplified explanation of options and futures, generally, if the price of that commodity or underlying asset rises (usually against market expectations) within a set time frame, an investor can close the futures contract at a profit. Thus, if an investor makes money from that bet, there will be a corresponding loss, and the net result is a transfer of wealth from one investor to another.https://www.investopedia.com/terms/z/zero-sumgame.asp
Speaking of the “for me to win, you have to lose” line of argument, consider this snippet of an excellent conversation between Tyler Cowen and Clifford Asness:
AUDIENCE MEMBER: How confident can you be that there will continue to be the steady supply of stupider investors on the other side of the trade so that you continue to make money?https://conversationswithtyler.com/episodes/cliff-asness/
ASNESS: That’s a great set of questions.
Backing up, you’re not going to believe me, you’re going to think I’m just copying you. But myself and a colleague, Antti Ilmanen — he’s Finnish, he didn’t just have odd parents — have been planning, we haven’t written it yet, to write a paper with the literal title, “Who is On the Other Side?” Just a little shorter version of what you said, because we do think that is a very disciplining question.
In fact, if you ask me, this is the core differentiator between economics and finance. The study of economics is (ought to be?) about non-zero sum games. The study of finance is about zero sum games. It’s confrontational, it’s risky, it’s like sports. For there to be a winner, there has to be a loser.
Why I like watching and playing sports even when sports is very much a zero-sum game is also another post by the way. One day.
Still, back to my main point: finance is a zero sum game.
If you want to get into this jungle, do so with eyes wide open. I’m just sayin’.
One thought on “Understand the beast that is finance”
No doubt, options is a a zero sum game but majorly every thing is derived by equity markets and being sensible you can make money without other person losing it and yes it does add too much of value in the ecosystem.
Looking forward to hear it from you Sir!