Saturday, 12 May 2012

Zero-Sum Game - The Perils Of Day Trading

In the film Wall St, the protagonist Gordon Gekko advocates that the stock market is a zero-sum game. This basically means that every dollar he makes, someone else must lose, because the net change in wealth must be zero.

There is much conjecture about this on the net, with many people arguing for and against.

Investopedia.com notes that ''A stock market is not a zero-sum game because wealth can be created in a stock market.''

I agree with investopedia, in the long run wealth can be created. The average (decent-profitable) company should grow at least in line with inflation (i.e. it passes it's increased input costs to it's customers), as well as returning a share of it's profits in the form of a dividend. Taken very roughly if you imagine average inflation to run at about 3% and average dividends also being about 3% it comes as no surprise that long term gains from the stock market equal about 6-7%
Obviously a great company will grow far faster than inflation and possibly distribute a higher proportion of its wealth, leading to much higher gains, compounded further if dividends are re-invested.

In the short run however, I think Gekko is right. Day traders like himself do not hold stock long enough for any wealth to be created, so it is in fact, a zero-sum game. If you take into consideration dealing costs it is actually a negative sum game. No surprise then that the vast majority of day traders lose money, to the benefit of a lucky few who usually have a competitive edge.





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