A quick note about markets and zero sum games

Just a quick note today about the stock market. One thing you frequently hear capitalists say to defend the system is that “the free market creates wealth.” Then they cite the stock market as an engine of wealth creation, which allows prudent long term investors to retire wealthy. As everyone buys stocks the price goes up over time and everyone wins. The problem is the stock market creates no wealth, but is a zero sum game. No investor gains a dollar that does not come directly out of someone else’s pocket.

A poker game is a good example of a zero sum game. A number of players with an amount of money between them play hands, some win and some lose, and at the end of the game they walk away with the total amount of money exactly the same. No matter how long they play or how many bets are made this obviously stays true. Of course if they play in a casino it changes a little because the house takes a cut of each pot, but that just makes it an even better analogy for the stock market where investors lose small amounts of money to commissions on each trade.

The market is similarly a zero sum game. There’s two ways to verify this. The first is the simple accounting that for every share bought, it is sold by someone else for the same price. Every transaction nets to zero. For some reason this still doesn’t convince people who believe that the other shareholders who own the stock may gain wealth as a result of the price having risen due to the transaction. I don’t know why it’s not obvious that the shareholders don’t have that wealth until they sell, at which point there is another zero net transaction, but for grins let’s move to the second proof.

Imagine the entire stock market consisted of Acme company, and the investors Bob, Ed, and Joe. Acme has 100 shares of stock it sells for a dollar. Bob buys them all, giving his $100 to Acme. Then Ed decides Acme shares are a great value and buys them from Bob for three dollars a share. Bob has Ed’s three hundred dollars. Joe reads Acme financials and notices a problem, which worries Ed. Joe offers to buy the shares for $200 and gets them. But it turns out that Joe was devious and knew Acme would have an excellent year ahead. Finally Acme makes a huge amount of profit and buys back all the shares from Joe to become private again for $400.

Let’s tally that up: Bob made a profit of $200, Ed lost $100, and Joe made a profit of $200. Overall that’s a profit of $300 for the investors, right? The market created wealth for most of the investors! The thing everyone forgets is that Acme gained $100 in the initial offering and spent $400 to delist their stock, which is a $300 outflow of cash from Acme. That’s exactly the amount the investors gained. The market itself didn’t make them wealthy, Acme’s profits made them wealthy. Spend a minute and think of the same situation with thousands of investors and companies. In the end the total profits from investors are always balanced by the initial offering and the end result of the stock, be it from bankruptcy, acquisition, or the company repurchasing its shares. The market itself is only a transfer mechanism. It’s a game of poker. The fact that stocks trade for many years and their market capitalization often grows enormously doesn’t mean the market is creating wealth any more than a long game of poker with lots of hands and a big pot creates wealth. The market is like a game of poker where people continually join and leave the game, bringing their money from elsewhere, but ultimately the final tally of the game must be zero.

In case someone thinks “wait, but what about dividends,” that’s not different in the slightest. A dividend is just another way for money to be transferred from the company to the investor. In fact, the share price is lowered by the amount of the dividend upon payment, so in reality the investor is no further ahead. People will protest that the price often goes back up after, but of course that’s just because investors resume buying shares with new money, even if that money comes from the dividend. The market itself still creates no wealth. It’s only a transfer mechanism, no different than poker.

What’s curious about this argument is how hostile many people become when confronted with it. I’ve had people tell me I’m an idiot, that I don’t understand open systems, or economic activity, or whatever. All of those people so far have merely ignored both of the arguments I’ve put forth here while insisting I shouldn’t talk until I learn what I’m talking about. I consider that kind of argument to be a tacit admission that they don’t understand the argument and don’t want to. The hostility is something I can only compare to what’s faced when someone’s religion is challenged: rather than argue the merits, often the person simply becomes enraged that the other is challenging their beliefs. I’ll leave you to consider what that means.

Something else to consider, in case transfer of wealth from companies to investors was starting to sound pretty good for the little guy: ask who is benefiting from market action. Every stock that is still trading is a game of poker that has not yet ended. Some of the traders, like hedge funds and investment banks, are making hundreds of billions of dollars in profit every year. Since the companies they’re trading are still public, that profit didn’t come from repurchase by the companies whose shares they have traded. Like Joe, they got their money from another investor. Who are the investors the hedge funds and banks are taking their profits from? It’s mostly the small time individual investors. Who else could it be? Keep that in mind the next time a hedge fund manager buys a 300 foot yacht, while you’re afraid that your retirement account doesn’t even have as much in it as you contributed.

About American Socialist

History major turned engineer
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