Pragmatic Capitalism

Capital for Living a More Practical Life

Is the Stock Market a Zero Sum Game?

I got this question in the forum over the weekend and I think it’s an important one since I seem to get it quite often.   It’s interesting to note that there doesn’t actually seem to be a very good answer online (at least not as far as my brief search went) so I used a short (and probably overly simplistic) example to describe why the description of zero sum is incorrect.  This also works into the concept of “moneyness” in Monetary Realism quite nicely as you’ll see that the stock market doesn’t necessarily increase the amount of money in the system, but can increase/decrease our wealth.

“This concept confuses a lot of people, but it’s important because it touches on how stocks are money-like, but not necessarily high on the moneyness chart (because they must be converted into deposits in order to be used for transactions). Let’s work through an example that will help.

Let’s say you have 3 people and 1 corporation. And the 3 people all have $10 for a $30 total. And then the corporation decides to raise capital so it issues 4 shares of stock at $4 or $1 per share. Let’s assume two of our people buy the entire issue and become owners of 2 shares each for a total of $2 each ($1 per share). So our corporation has $4 and our two investors own 2 shares each valued at $1 per share ($4 market cap).

Then, a year later, for whatever reason, investor 1 decides the stock is worth 100% more and tries to sell it on the stock exchange where person 3 purchases the 2 shares for $2 each ($1 higher than the IPO price). Now person 3 owns 2 shares each valued at $2 for a total of $4 and person 1 has $12 TOTAL of which $2 is their capital gains on the stock sale. Person 2 still own his 2 shares that are now worth $4 total ($2 unrealized cap gains).

Is there more money in the system? No. Person 1 has $12 (he had $10, invested $2 and generated a return of $2 for a total of $12 in net worth). Person 2 has $8 and shares of stock that he believes are now worth $4 (ie, he think he’s worth $12). Our corporation has the $4 they raised from investors 1 & 2. Person 3 has $6 plus shares that he thinks are worth $4. But look what’s happened here. Our little economy is actually worth more! Person 1 has $12 where he once had $10. Person 2 has $8, but thinks he’s worth $12. Our corporation still has the cash of $4. And person 3 has $6 plus the shares worth $4. So our corporation can invest the $4 in its operations, person 1 has benefited from his investment by increasing his net worth by 20%, person 2 is worth 20% more (at least on paper) and person 3 is where he started but hopes the corporation will make wise investments so he can benefit like investor 1 did.

I think I got all those numbers right there. So, zero sum isn’t the right description in that a stock market can actually increase the overall wealth of its participants (at least on paper)…Also, I basically just described QE where people bid up stock prices without the underlying corporations actually changing anything. The economy is technically worth more, but that could be a mirage for all we know. This society’s obsession with unrealized stock market wealth is, quite frankly, absurd and misguided. It’s a real-time example of counting your chickens before they hatch.”

The key point of this discussion is that the stock market reflects the market value of stocks and comprises a substantial portion of private sector net worth.  Over the long-term this reflects the market’s expected value of the underlying corporations.  As the aggregate economy expands we should expect to see more valuable corporations as they create goods and services that become more valuable.  That is, the economy expands and the stock market expands with it to reflect improvements in living standards and goods and services produced. Importantly, this is a positive sum system in the long-term because the pool expands as a result of market value changes.  This is very different from a zero sum game like a poker game which experiences an expansion in the size of the pool only when more people join the pool and not because the assets in the existing pool change value. Said differently, at the transactional level the stock market is a negative sum game (after taxes and fees) in the short-term, however, it is a positive sum game in the long-term assuming share prices increase in value to reflect higher future expected cash flows.

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