In the economic field there are many theories that focus on the study of market behavior and the decisions made by individuals in different scenarios. One of these theories is the “zero sum” game.
Zero-sum game theory holds that one individual’s gains are another’s losses and vice versa, so the net profit in the market is zero. This can happen regardless of the number of participants, what is important to highlight is the net benefit, in other words, the transfer of utility.
Although “zero sum” games are rare in everyday life, they do appear regularly in the financial markets, mainly in futures and options contracts, which are perfect examples for this theory.
Grounding the concept a bit, imagine that a coin toss is going to take place between two people, in which there are two possible outcomes: eagle (you win) and sun (the other person wins). The person who has selected the winning face will receive a coffee paid for by the loser. By being winners at the toss, you make a profit and the other individual makes a loss; the net profit in the “market” would be zero, thus respecting the theory.
Setting it in the financial markets, one can imagine that, after carrying out the necessary analysis, the decision is made to invest in company “X” since its results for this year are forecast to be better than the market estimate. On the other side, you have another individual, “Mr. Z ”, who believes that his shares in company “ X ” have appreciated enough and makes the decision to sell his position.
The zero-sum game begins the moment the transaction is made and one gives up the cash for the other person’s actions. It must be assumed that at the end of the year the stock had a positive return of 15% and that this decision was the correct one, while “Mr. Z”, made a 5% return by selling his position early, so the market averaged a 10% return. The “zero sum” is found in that 5% that was obtained extra and that “Mr. Z” stopped winning. The 10% return obtained by the market would be the percentage of net profit.
There are other factors that have to be taken into account, such as commissions, taxes and other costs, that make the “zero sum” theory a little different than what the books explain.
Despite positive returns, a good conclusion that can be drawn from this is that there is always a winner and a loser in the market and that the correct analysis is very important for decision making and maximizing profits. You must have clarity and firmness in decisions, as well as understand that time, above all, is a key factor so that the investments made by each person are the ones that take that extra benefit versus the benchmark.
The author is Front Manager Investment LATAM – BBVA Asset Management
