Last Updated on 10 February, 2024 by Abrahamtolle
Is Trading And Investing In The Stock Market A Zero-Sum Game?
Trading and investing are two types of activities we see on the financial market, and they both are aimed at gaining profit. The two methods are extremely different, even though outsiders look at the them as tools used to trade. Traders and investors seek profit when they participate in the market, but the way they act to gain that profit is completely different. Generally, the investors are looking to gain more profit over time, while traders assume a higher degree of risk and play to gain small, frequent profits in a short period of time.
There are voices that say trading and investing in the stock market is a zero-sum game, similar to gambling. While that is true to some extent, it does not apply to all the actions made on the financial market. Investing is different from trading and it hardly represents a zero-sum game. Meanwhile, some types of trading are more like a gambling game and can be classified as a zero-sum game.
There are multiple faces to the same problem. However, to better understand the financial market and what makes trading a zero-sum game, we must take a look at the definitions of the two and also gain in-depth insights into what actually is a zero-sum game and what value it adds to the market. This will help clarify the concept a bit and make a better distinction between investing and trading.
- The major differences between investing and trading
Investing and trading are two different tools used to reach the same objective on the financial market. Both traders and investors seek profit from their actions. However, the two don’t share as many similarities as you may think.
Investing is a way to build wealth in the long run and through complex actions. Investing requires a deep knowledge of the market and its instruments. Investors build a portfolio over time, comprising of various financial tools, such as bonds, mutual funds or stocks. Investors know their way around the financial market and often learn to enhance profits through reinvesting or compounding dividends or profits into shares of stock. People who invest often build their wealth and portfolio over large periods of time and focus on stock splits, interest and dividends to increase their profits. Investors tend to focus more on market fundamentals, such as management forecasts or price ratios, rather than market fluctuations.
Trading is the opposite of investing as it is carried out over a shorter period of time with the desire to gain fast profits. Traders often have frequent transactions and work with financial tools such as commodities, stocks or currency pairs. As mentioned earlier, the main goal of a trader is to generate fast returns and their game is to buy, hold and resell based on the price fluctuations that take place in the market. Investing may bring you a 15% return on an annual basis, but traders seek more fast profit and expect 15% return on a monthly basis, for instance. There are various types of trading, depending on the time frame the action takes place, and you may find scalp traders, day traders, swing traders or position traders in the market. More factors are involved in choosing a trading style such as account size, level of experience, time dedicated to trading and the amount of risk accepted by the trader.
The investment market is more stable and more complex than the trading market and that’s exactly why it cannot be called a zero-sum game. Some types of trading, on the other hand, are very similar to zero-sum games. FEL
- What is a zero-sum game?
A zero-sum game is actually a game theory. A zero-sum game situation is when a person gains something, while another loses the equivalent of that something. The net change in benefit or wealth is zero in the end. A zero-sum game may be played by two people or even by millions of people. Some very good examples of zero-sum games are gambling games, such as poker, or other types of games, such as chess. Zero-sum games assume perfect information and perfect competition. Therefore, both opponents playing the game have enough information to make a good decision.
Zero-sum games are, however, less common in real life than non-zero-sum games. In fact, zero-sum games are the complete opposite to a win-win situation, such as an agreement of a trade, or to a lose-lose situation, such as a war. However, it is difficult to make a clear distinction in real life because things are more difficult and cannot be perfectly quantified.
- If trading is a zero-sum game, does it bring any value to the market?
Some types of trading can be named zero-sum games given their nature. Very good examples of zero-sum games on the trading market are futures and options. That’s because every person that gains a contract directly affects another person who loses that contract. These two examples are the closest to a zero-sum game in trading because they look like an informed bet on the future cost of a commodity. This is done in a defined time frame, which makes it look like a bet. If a trader makes profit from a contract, another one will have the same amount of loss to suffer.
However, trading with futures and options still has value on the market because these two financial tools provide liquidity. This means that the markets where the trading is being done can become successful choice for the right company or investor.
Trading is ultimately part of the financial market and has an important role in the overall picture. Most types of trading cannot be simplified to a zero-sum game as there are more factors involved than a win and a corresponding loss.
- HFT trading and its impact on the market
HFT or High Frequency Trading is a type of trading that uses algorithms to replace the role traders have on the market and automate the entire trading activity. The profit earned on a trade is very small, but high frequency trading is based on the amount of orders executed in a very short period of time (milliseconds) and eventually helps traders generate good profit.
High frequency trading is a very controversial practice and it had a dramatic impact on the market since it first started. While some argue that this is the natural step ahead for the financial markets, others are reluctant to it and believe it has negatively affected the way markets work.
High frequency trading can analyze multiple markets at the same time and rapidly execute orders based on the existent conditions on the market in that moment. This type of trading is also called predatory and superfluous but some look forward to benefit from it. The US market, for example, was dramatically affected in a short period of time by the use of HFT. The money volume coming from investors and managers has been consistent for more than a decade. However, over a short period of time, the amounts traded more than doubled. The HFT strategies are definitely affecting the way financial markets work.
In conclusion, investing and trading are two very important actions on the stock market. And, even though at some degree trading can be viewed as a zero-sum game, these two tools are more than gambling and require a deep knowledge of finance, the market and types of worthy investments. In the stock market, as with anything else, it’s important to stay up to date with any changes, build a strong portfolio and a diverse experience while working towards your objectives.