Ask the majority of people about investing and they will probably tell you that when the stock market rises, everyone wins and when it drops, everyone loses. But this isn’t the case. Investing in the stock market is not a zero-sum game. You have investors making money and losing money every single day, regardless of what the market does.
How is this possible? In this post, we will look at what a zero-sum game is, why investing doesn’t fit the definition, and how you can make money, regardless if the market is rising or falling.
What Is A Zero-Sum Game
You now know that investing is not a zero-sum game. But what exactly is a zero-sum game? Game theory was first introduced by John von Neumann in 1944 in his book, Theory of Games And Economic Behavior.
It takes into account various factors, including gains, losses, individual behaviors and more.
The classic definition of zero-sum game is when one person wins, the other person loses. For example, if you and I are playing poker and my hand is better than yours and I win, then you lose. I take the money in the pot.
In other words, the winner takes the money and the loser is left with nothing. Understand that a zero-sum game can happen between two people or hundreds or even millions of people. All that matters is there is a winner and loser.
Why Investing Is Not A Zero-Sum Game
Now that we know exactly what a zero-sum game is, how is investing not this? After all, when I sell a stock that I’ve lost money in, I am losing aren’t I? Not necessarily.
First off, it is important to know that part of zero-sum games is that it assumes all parties in the transaction have all of the information to make the best decision. When it comes to buying or selling stock, both parties don’t have all the same information. One might have more information or better information that leads them to believe a stock is worth buying or selling.
As a result, they make their informed decision based on what they know.
When it comes to the money aspect, just because someone is selling a stock it doesn’t mean they are losing money. They might have made a substantial gain and are looking to lock in this gain. Or they may decide there is another investment that better fits their needs.
In either case, both parties of the stock transaction can come out winners or even losers.
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Where Investing And Zero-Sum Games Do Cross Paths
While investing in stocks, mutual funds, and ETFs are not considered to be a zero-sum game, trading options and futures could be classified this way. This is because investors are making bets based on information they have as to the future price of a stock or commodity.
Most times when one investor is right, the other investor is wrong, creating a winner and loser in this scenario.
How To Make Money Investing In The Stock Market
So how do you go about making money in the market, regardless if the market is moving higher or lower? There are a few things you can do.
- Have a plan. The better planned out your investment strategy is, the greater the chance you will have of long term success.
- Invest in a diversified portfolio of stocks and bonds. Since these investments tend to perform opposite of each other, you can limit any potential loss.
- Place stop-loss orders when buying stock. A stop-loss order will limit any potential loss you may experience.
- Buy and sell options. Doing this can help you to make money when the market is dropping or even when it is rising.
- Invest in contrarian instruments. If the market is rising, you can invest in ETFs or mutual funds that have bearish sentiment. This means when the market begins to drop, the investment will rise in value. On the flip side, when the market is falling, you invest in bullish sentiment investments that will rise in value when the market begins moving higher
Overall, don’t make the mistake thinking that investing in the stock market is a zero-sum game. It isn’t. It is not a given that one party in the transaction is a loser while the other party is a winner. Both can be winners or both could be losers. And one could win and the other could lose.
But investing doesn’t fit the definition of a zero-sum game where there is a winner and loser in every single transaction. That is gambling, not investing.