Personal Finance Blog | FlipSide Invest

I will never forget my first investments class in business school. After finally completing core classes, I was so excited to learn about how to make money in the stock market. Of course, the first words my teacher said were, “Ok class quiet down… Welcome to Investments 301. Let me start by saying we will not be learning how to make money this semester because I honestly couldn’t tell you.”

Reality sets in these days as I now realize why he had such a futile perspective. But if we aren’t making money, who is? What are our failures offset by?

Generally speaking, a zero sum game is one where the gains and losses in a situation net out to zero. To see its relevance to finance, I quote the movie Wall Street, where Gordon Gecko says:

“It’s not a question of enough, pal. It’s a zero sum game, somebody wins, somebody loses. Money itself isn’t lost or made; it’s simply transferred from one perception to another.

Gecko’s statement is based on some bold assumptions, like the exclusion of labor productivity’s growth (see Endogenous Growth Theory for you econ folks). But most theories require some form of assumption to be applicable in the

real world. At any rate, he seems to be the personification of the behind the scenes profit-taker the average investor is competing against.

Let us look at the U. S. equities market. This is the oasis for all creatures of the jungle: mutual funds, investment banks, hedge funds, day traders, institutional investors, your every day average person trading on his or her personal account, etc. The proliferation of the internet, electronic trading systems, lower commissions on trades and other such factors have helped to make this market highly liquid (liquidity is the ability to exchange one asset for another quickly and without loss of value; example: four quarters can buy a dollar, but can a house purchased for $100,000 be sold for $100,000 very easily?). What draws all these players into the market? The most obvious answer is that we are all searching for profits.

Next point: your average every day investor buys stock and hopes it will go up in value or pay strong dividends (company profits). Most financial professionals and scholars believe markets are close to efficient, meaning prices reflect almost all past and present public information. Again, more readily available information via the internet makes this more true than ever. Therefore, very few people should be able to make abnormal gains. In the next posting, I will get into what really determines prices, but for now, let us all just remember that the price is what some one is willing to pay for the security. Generally speaking, it is some combination of a company’s current value based on expectations about its future combined with qualitative perceptions about the company. In reality, a true price never exists. Does the average investor really get into a price analysis? Does he or she chop up the financial statements in search of free cash flow or interest coverage? Does he even know what these are? I would say most likely not. And yet, the status quo is to dump all our savings into markets we do not even understand!

Another point: Who is the Michael Jordan of the stock market? Before we get into that, look at the last point and you might have thought to yourself, “Oh I understand… forget this blog.” Well, let me enlighten you all on another something we learned in business school: how to derive the best average investor in the stock market. Let us assume that there are currently 100 million stock market investors in the NYSE. If each investor was given a quarter (25 cents for the slow ones), and each investor wins (made a profit) for landing on heads, and each investor did a daily flip, common sense says approximately 50 million will be winners on day 1. On day 2, 25 million will win and so on. By day 23, there would be only 23 winners. At this point, I am quite sure the 23 would be supremely confident in their ability to flip a coin and land heads. They would write how- to books with titles like, “Flipping quarters: a legend speaks;” they would give lectures on proper technique; they would be studied; the media would write stories of their greatness. After 25 days, there would be only 5 people left, revered as gods of the quarter flipping universe. Soon enough, the Michael Jordan of the game would emerge. This analogy may seem long winded, but its application is simple: it is easy to attribute our successes to skill and our losses to bad luck in the market. The amount of unknown unknowns are striking, and even the best only get it right 60% of the time. The average investor must be careful not to confuse a profit taking move as luck. If you read an article in the news and bought stock based on just that, you are one of these people. If you had a hunch and did no homework to support it, you are one of these people. I am relatively certain you have bragged when it went your way, and wrote it off when it didn’t. Your blind guesses, when luck is not on your side, will be your loss and another’s gain.

Final introductory point: to summarize, there are more players than ever with more tools at their disposal, and yet the every day investor on average still cannot beat the S&P. So who is making all the money? Why even attempt to actively invest? Sometimes I do wonder if it is worth it. Perhaps purchasing an ETF on some broad indeces really is the way to go for us. The last thing we want to do is to be sheep, because sheep get slaughtered.

Coming soon: Zero Sum Part 2: the Wolves