Wealth creation: Zero-sum games - a killer virus

Continuing from risk vs. returns, we move forward to compare and contrast activities which create or destroy wealth.

An activity or a part of a business that does not create any value cannot exist. If one does, I am sure you would be surprised. It would not exist only if the users or clients realized that it does not create value.

Let us take the example of stock trading. There are professional day traders. Their objective is to make money by spotting trading opportunities, e.g. arbitrage or intra-day price movements. Day traders are an essential part of the market eco-system. They provide the much needed volumes or liquidity that really adds depth to the market and attracts investors.

But, if day trading is not your profession, should you be placing bets or ‘punt’? Let us understand this better before deciding. On a daily basis, the total gains made by people who won (through day trading), will be equal to the total losses made by people who lost.

Investopedia.com says – “What does Zero-Sum Game mean? A situation in which, one participant's gains result (only) from, another participant's equivalent losses. Options and future contracts are examples of zero-sum games (excluding costs). Gambling is also an example of a zero-sum game. The stock market, however, is not a zero-sum game, because wealth can be created in a stock market.”

The last qualifier is very important. This is because over a period of time, a business, which is the underlying activity behind any stock, delivers in terms of sales, profits and creating return-generating assets. These are wealth creating steps. The stock market thereby becomes instrumental in improving the efficiency of price-discovery; and contributes in recognizing and aiding wealth creation.

For creating long-term wealth, actions should aim for minimizing risks for the same level of returns or enhance the returns without increasing the risk. Or, improve the returns per unit of risk. Day trading like zero-sum games is to be avoided at all costs.

2 questions to ponder over –

* Will an investment with a 50% chance of making money qualify for long-term wealth creation?

* Should SEBI mandate stock brokers display a warning “Day trading is injurious….and can also kill you financially”?

Buffet-speak “Only buy something that you’d be happy to hold even if the market shuts down for 10 years”!