Understand the beast that is finance

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.

It is not a non-zero sum game.

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?
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.

https://conversationswithtyler.com/episodes/cliff-asness/

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’.

Links for 4th March, 2019

  1. “Under Uma, the NRCB has built Asia’s largest gene bank of 360 banana varieties. The popularity of Grand Nain—the long, pale yellow bananas that one encounters in most supermarket shelves (promoted by the giant Swiss horticultural conglomerate, Chiquita)—is such that it has been pulping production of more nutritious native bananas. Monoculture, or large-scale cropping of one strain without diversity, makes the crop susceptible to deadly disease attacks that could wipe out its production. There’s also the added risk of permanently losing indigenous varieties. This is one of the many threats Trichy’s famed banana growers face. The perennial scarcity of water has also meant that Tamil Nadu’s Theni district toppled Trichy from its top banana status. ”
    Only one excerpt from a very long article about the Cauvery  -and this long article is only part deux of a two part series. There was much to learn from reading it, about a whole variety of issues. Recommended.
  2. “Economic historian Barry Eichengreen has shown how countries that have experienced rapid economic growth during their escape from the clutches of mass poverty tend to falter in their subsequent move to mass prosperity. His research suggests that the most common point when inertia sets in, is when average incomes are either around $11,000 or $15,000 a year. This is the famous middle income trap. Fewer countries emerge from it than enter it.”
    Recommended for a variety of reasons – a good way to learn about the middle income trap, about China’s slowdown, about India’s opportunities, and about the implied risks for both China and India. Niranjan Rajadhakshya on China’s slowdown.
  3. “Ms. Ocasio-Cortez’s policy adviser, Dan Riffle, contends that “every billionaire is a policy failure” (that’s the tagline on his Twitter handle) because “the acquisition of that much wealth has bad consequences” and “a moral society needs guardrails against it.” He’d like to see the 2020 Democratic primary contenders answer a question: Can it be morally appropriate for anyone to be a billionaire? ”
    Or, put another way, is the world a zero sum game or  a non-zero sum game? This blog is unapologetically in the latter camp. Economics, in fact, is defined by being a non-zero sum game.
  4. ““I’ve been very cautious about saying that until we got these results, but now I’m not so sure,” he said. “I think that a striped T-shirt might work very nicely.””
    The most fun way you will ever learn about evolution. Well, maybe not the most fun way, but you’ll enjoy reading this for sure.
  5. “As the process of Brexit unfolds, we are discovering how many pleasant aspects of modern life in Britain are closely linked to EU membership. A good relationship between Britain and Ireland should be added to that list.”
    Gideon Rachman on how Brexit might (make that will) affect relationships between Britain and Ireland.