Are the Economy and Financial Markets Zero-Sum Games?
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Audible. There's more to imagine when you listen. Go to audible.com slash imagine and discover all the year's best waiting for you. Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 432. It's titled, Are the Economy and Financial Markets Zero-Sum Games?

One of the most thrilling and heart-wrenching aspects of sports, particularly annual NCAA basketball tournaments, is watching a team come from behind and win in the final few seconds. There's the sheer joy and delight of the winning players and fans, and the shock, disbelief, and even tears of the losing players and fans who realize their season is over.

I recall attending an NCAA tournament game with my father's alma mater, Xavier University, being in the stands with him and seeing the opposing team make a last-second shot. And the roar of the crowd for the other side and the disbelief in seeing our team lose. A basketball game is a zero-sum game. In order to have a winner, there must be a loser.

Federal Reserve economist Eric R. Nielsen describes a zero-sum game as follows. Mathematically, a zero-sum game is one in which the sum of all the gains and losses made by all the players must be zero. This is the familiar idea that one man's loss is another man's gain.

Nielsen gives an example of a game of poker where the total amount of money in the pot at the end of the game is the same as at the beginning. Money made by one player with a winning streak comes at the expense of the other players. There are some aspects of financial markets that are zero-sum games.

Trading commodity futures, for example. If I go long oil expecting oil to go up in price, and if the price of oil rises more than the price of the futures contract when I initiated the trade, then I'll make money. But that money that I earn comes from the trader or traders on the other side of the trade who were shorting oil, speculating that it would fall in price.

The zero-sum game of commodity futures, of currency trading, is one reason they're so incredibly difficult to get an edge in order to make money. Another example of zero-sum games is trying to generate excess returns, or alpha, through security selection in the stock market.

Nobel laureate William Sharpe, in a piece from 1991 titled The Arithmetic of Active Management, described why mathematically active managers underperform the market. He writes, over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using the beginning market values as weights.

What that means is the return of, let's say, the S&P 500 index, a measure of U.S. large company stocks, its return is the weighted average of the underlying individual stocks that make up that index.

Sharpe continues, each passive manager will obtain precisely the market return before cost. So that'd be an index fund and a passive ETF. And then Sharpe says, from this, it follows as the night from the day that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market.

If the first two returns are the same, the third must be also.

In other words, passive investors will earn the return of the market, which means that active investors collectively, on average, will earn the return of the market, and that active investors, active managers, because they have higher fees, they'll collectively, on average, trail the market. A few episodes ago, we interviewed Carl Gleisch, who's the CIO of Harbor Capital, and he equated this situation

seeking for alpha or excess return as a zero-sum game.

He said, I'll make the statement that most active managers will underperform, and we should expect them to because investing is more or less a zero-sum game in the secondary markets, give or take, share buybacks and IPOs. Let's put those to the side and just say it's a closed system, and for every buyer, there's a seller, and for every seller, there's a buyer. So the way I view active managers, they're no different from any other sport where they're competing against one another.

And the average manager, by definition, is going to kind of underperform net of fees versus low-cost index funds. And then indexing funds exist because all of those different active managers are going through a process of setting valuations on underlying securities. And if they do a pretty good job of doing that, then index investing can kind of exist.

What he's getting at is active managers are setting the value of what securities are priced at. The price of a security represents the consensus of what active managers believe a stock should be worth based on the present value of its future cash flows. We need those active managers that are analyzing companies, analyzing their prospects, and setting, essentially in a fairly efficient market, the correct price.

Not always the case. Sometimes we do get stocks that are mispriced, but it is the active managers seeking to add excess return that allows for passive index funds to exist. Collectively, though, the passive returns and the active returns equal the overall market returns.

On this topic of active management, I found this article by New York Times financial columnist Jeff Sumner. He pointed out in 2022 that conditions, in his view, heavily favored stock pickers, active managers, but that most trailed the market.

In 2022, the S&P 500 returned negative 19.4%. The index funds match that return. An S&P 500 index fund returned very close to negative 19.4%. But if we look at the overall market, the mega cap tech stocks, so Alphabet, which is Google, Amazon, Apple, Meta, Microsoft,

Those stocks which make a bigger portion of the index fell more than the average stocks. And so the average stock in the S&P 500 did better than the overall index. In fact, if we look at the return of the equal weighted S&P 500, which every holding gets the same weight, that outperformed the size weighted S&P 500, which is how

how it's typically looked at, capitalization weighted, the equal weighted outperformed by seven percentage points in 2022. But if we look at active managers, 51% of large cap stock funds

underperformed the S&P 500. Now, Sommer points out that if we, as individuals, randomly selected stocks last year in the S&P 500, we had a better shot of outperforming the index because most of the stocks did better than the S&P 500. So why is it that active managers still underperformed? At least my interpretation of Sommer's was that they should have done better, but I don't necessarily agree with that.

We know that in aggregate, active managers' stock holdings and their weights will underperform net of fees. On average, they will underperform. The only way that in any market, including a market where the average stock does better than the index, the only way for most active managers to outperform is if the largest asset managers, overweight mega cap stocks, and average

underweight the smaller holdings within the S&P 500. And then you have the smaller managers that have smaller levels of assets under management. They overweight the smaller holdings within the S&P 500 and underweight the mega cap stocks.

So on an acid-weighted basis, the active managers are still underperforming. But if we just base it on the number of active managers, if the smaller managers, where there's more of them, they outperform because they're underweight, the mega cap stocks, then you could have it. But that's not what happened.

We still had 51% of the managers underperform, and that's better than your typical year. So there must have been some overweight of the mega cap stocks by some of the bigger managers. But still, most active managers underperform, and it gets worse over longer timeframes.

S&P Dow Jones does an ongoing study looking at how actively managed funds compare to index funds. From 2010 through 2021, in any given year, 55% to 87% of actively managed funds underperforms.

That's what we would expect based on the arithmetic. But if we look over a three-year period, 74% of active managers trailed the index, 86.5% on a five-year basis, and over 90% on a 10-year and 20-year basis.

Seeking excess return through stock selection is a zero-sum game. For every outperforming manager, there has to be one that's underperforming.

Now, perhaps you're not an active investor in terms of stock selection, but what about country weights? If we look at the global stock market right now, as measured by the MSCI All-Country World Index, is around 61% U.S. stocks. The second largest country is Japan at around 5.5%.

As an investor, if you allocate 85% of your stock portfolio to the U.S. and 15% to non-U.S., that means other investors need to be underweighting the U.S. and overweighting other areas. Japanese investors, for example, would need to have more than 5% in Japan. In a paper that's coming out next month in the Journal of Portfolio Management by Cliff Asness, Antti Hilmannen,

and Dan Villalon. They all are with AQR Capital. The paper's titled International Diversification, Still Not Crazy After All These Years. And they talk about how diversification is fundamental and important to modern finance because that's how markets work. They write, this is because the only market clearing or macro consistent portfolio is one that's market cap weighted, where one individual

Investors overweight is another investor's underweight. That's what makes a size-weighted or cap-weighted market. Passive managers owning the size-weighted portfolio, active managers, some overweighting some holdings, underweighting others, collectively that forms the market. And because of fees, the active managers underperform. But on a country-weighted basis, they

They point out if anyone decides that they're best off holding mostly their own country's equity market, then it means other investors in other countries must also be more home biased. The trouble with this proposition is that it's simply not logical for investors in every country to believe their home market is going to outperform. It may be patriotic, but it sure isn't rational. A rational investor would own a

a size-weighted portfolio and not overweight a particular market unless they have a reason to do it. Now, in my portfolio, I am overweight non-U.S. stocks, as are the Money for the Rest of Us Plus adaptive model portfolios.

The reason for that is we expect non-U.S. stocks to outperform over the next decade or so for the reasons that we've discussed on the podcast and that AQR points out in their paper, that the U.S. has outperformed over the past 30 years because U.S. stocks have gotten more expensive than non-U.S. stocks. Based on their analysis going back to 1990, that

Increased price-to-earnings ratio for U.S. stocks added about 4.6% per year to the excess return

of U.S. stocks versus non-U.S. stocks. And so our view is going forward that non-U.S. should outperform because it has a higher dividend yield and the earnings growth should be comparable to the U.S. And then there is the potential for non-U.S. stocks to get a little more expensive, but we don't know. But we have to recognize that that is an active bet.

To be truly passive would be to own the global market on a size-weighted basis, and that would include 61% in U.S. stocks, about 10% or so in emerging market stocks. Just buy an ETF like the Vanguard Global Stock Market ETF, VT.

If we look over the past decade, the U.S. stock market, the price-to-earnings ratio 10 years ago was 16.5%, and now it's 22%, and that contributed about 3% in additional return for U.S. stocks over the past 10 years, and U.S. stocks return 11.5%. Asness and his co-authors write, at a high level, there are two ways a country's equity market can beat the competition.

One, it outgrows on the fundamentals. And two, it outgrows on the price multiple to fundamentals. In other words, it can grow based on the cash flow, the dividend yield, the earnings growth,

how those dividends grow over time. And that's based on the fundamentals. And we look at that on a regular basis, that money for the rest of us. But it could also grow because investors are willing to pay more for that cash flow and that cash flow growth now versus later.

We don't know what's going to happen, but it's important to understand what drove returns, how much was due to the cash flow, the cash flow growth, valuation changes, and even the impact of currencies. And that's certainly something that we do at Money for the Rest of Us and we're going to make available to you and actually in an announcement that we have next month for something new we're bringing to the table.

Back in episode 421, we looked at survivorship bias, and we referred to a paper by Ivo Welch, who's an economist and professor at finance at UCLA. He looked at disaster risk, and he was particularly looking at the outperformance of the U.S. stock market. Based on the pricing of options, he determined that

there was a 37% chance U.S. could have had an 80% or greater stock market crash over the past 100 years. But it didn't. He writes, our concern is that there were a few high-magnitude left-tail realizations or black swans that happened not to have been observed yet because it didn't happen yet. In other words, the U.S. stock market may have outperformed

over the past 30 years because there wasn't a particular bad thing that happened. Now, there was the great financial crisis. There were things that happened, but it wasn't horrible 80% type decline. It was priced into options, the potential for it, that level of volatility, that level of drawdown, but it didn't happen. And maybe that's another reason the U.S. stock market outperformed, perhaps because investors got overly confident that, well,

Well, the U.S. is exceptional, not likely to have that level of drawdown. And so investors bid up the U.S. stock market, thinking that it was perhaps less risky, more comfortable, and that bidding up the valuations contributed even more to the outperformance. Before we continue, let me pause and share some words from this week's sponsors. Knowing where our money is going and how it's being spent helps us feel more at peace and

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That's joindelateme.com slash david20, code david20. We know then that excess return is a zero-sum game. Seeking to deliver that excess return through security selection or through country allocation or industry selection, that is a zero-sum game. Some will win, some will lose, but collectively, at least active mutual funds will trail because of the fees.

But what about the overall stock market? Is investing in the stock market a zero-sum game? Do the positive returns we earn over time by investing in a passively managed stock index, does that come at the expense of other investors? That income, the dividends that drive stock returns, those fundamentals, the dividend and earnings growth, is that a zero-sum game? If we look at the global stock market, current dividends, 2%,

2.4%. Earnings growth, if we assume 5.6%, that's an 8% annualized return. And that's what it was over the past decade, putting aside valuation changes and currency. If companies generated profits and income, publicly traded companies that trade on the stock market, if they achieve that from stealing from other households, businesses earn

or countries, then clearly that would be a zero-sum game. They would be winning but leaving others poorer. That's not how the global economy works. It's not a fixed pie. The global economy is a growing pie. And we know that because income and well-being has increased over time.

A couple weeks ago in episode 430, we looked at some work by economist Angus Madison, who calculated how GDP per person or per capita has increased throughout history. GDP is a measure of what is produced per

the monetary value of what is produced. And this study was done in 2011. And so it adjusts for inflation over time and showed that Western Europe, that GDP has gone from 914 in year one per person, the value of what was produced, to $40,364 in 2016. Overall wealth per person

Because GDP can also be calculated based on income. The income per person essentially has grown multiples as the economy has grown. Why is that? It's a function of innovation. The ability to produce more, produce things more efficiently. And that leads to greater wealth and income.

Nathan Metsch is the program outreach project manager for the Acton Institute. He wrote an article looking at the zero-sum game of the economy or looking at whether it is a zero-sum game. And he gave the example of a dozen people that are stranded on an uninhabited island and they're not likely to be rescued.

It's a fairly minimalistic economy. But then somebody discovers a grove of blueberry bushes and somebody else figures out how to plant more blueberries. So they're able to plant that and some other crops. Somebody figures out how to make a fishing rod so that they're able to catch fish. Somebody else figures out how to make mud bricks so they can build shelter.

Over time then, this little microeconomy is growing. The wealth is growing. Their ability is growing. Their well-being is growing. Their quality of life is growing. And that's what we're trying to measure when we're measuring GDP. Ideally, that output produced is leading to greater abundance, greater well-being. And that was very much the theme of episode 430. We saw that over time, life,

Life expectancy has increased, but the amount that needs to be produced to sustain those higher life expectancies and well-being is much less than what we typically think.

Now, this little micro-economy on this island, it depended on ingenuity, innovation, but it also depended on accessing natural resources. In episode 430, we refer to the work by British Indian economist Partha Dasgupta, and he talked about inclusive wealth, which includes capital, what is produced, it includes human capital, labor, knowledge,

But inclusive wealth needs to take into account if the biosphere is being used up, if it's not being sustained. And that's always difficult to determine. It's certainly something that needs to be measured because over time, if the biosphere is being destroyed, then that will reduce future well-being. I found some quotes, though, about predictions for natural resources being used up.

This is from John Williams back in 1789 in the Natural Survey of the Mineral Kingdom. He wrote, "...when our coal mines are exhausted, the prosperity and glory of this flourishing and fortunate island are at an end. Our cities and great towns must then become ruinous heaps, and the future inhabitants of this island must live like its first inhabitants by fishing and hunting."

About 80 years later, W. Stanley Jevons on coal says there is no probability, as in zero probability, that when our coal is used up, any more powerful substitute will be forthcoming. And clearly, that wasn't the case because we're able to produce even more power now than ever, even though coal as a percentage of power production continues to wane because we have natural gas, we have oil,

And we have renewable energy, solar, wind, geothermal, and hydropower. But even as recently as 1939, the U.S. Department of Interior said American oil supplies will run out in 13 years. So we never know when that barrier is, but it does behoove us to not be a catastrophist, but also recognize the cost of the use of these natural resources.

So the economy overall is not a zero-sum game. The pie is growing. The amount produced per person is growing. We need to factor in the cost of producing that. But clearly, innovation has taken a lot of people out of poverty. There are, though, some aspects.

The economy that is a zero-sum game, something called rents or rent-seeking. And it's when there are market distortions to where some people are receiving excess income, becoming wealthier and others poorer because of some artificial advantage or some distortion that shouldn't be there.

It could be the rules that are in place or the ability of companies to take advantage of rules, perhaps getting some legislation passed that favors their business over a competitor. So we can see that there can be aspects of the economy

where there's rent seeking, where a business is getting wealthier at the expense of someone else. That's why we have regulations to hopefully protect against that and protect against monopolies. And within any dynamic economy, there will always be some individuals that are worse off and others worse.

better off, and that's why we have social safety nets. But overall, if the economy is expanding and growing, or even if well-being is increasing, and that's the focus, the well-being, then that's not a zero-sum game. A zero-sum game is when there are both winners and losers and no overall increase in abundance or wealth.

We should think about the games or the activities we participate in and recognize if they're a zero-sum game or not. There are aspects of trading that clearly are trying to outperform someone else.

is a zero-sum game. We can think about status-seeking. This is from the book How Much is Enough by Robert and Edward Skidelsky. And they talk about a competition for wealth and status. They write, "'Once competition for wealth, or the consumption by which it is normally signified, turns into a competition for status, it becomes a zero-sum game, because everyone, by definition, cannot have high status.'"

As I spend more on prestige goods, I gain status but cause others to lose it. As they spend more to regain status, they reduce my own. There's no reason why the escalation of income to maintain and acquire status should ever end.

So there's another aspect of the economy. Trying to seek status, that's a zero-sum game. But if we focus on areas that we don't win at the expense of others, those are more abundant games. They could be called infinite games. Forming friendships, seeking out worthy goods, communing with nature.

contributing to the security of a neighborhood or country or some things that everyone benefits from. Friendship is not a zero-sum game. It shouldn't be. Everyone benefits. The abundance is there. But there are aspects of all financial markets and economies that are zero-sum games. But overall, the economy and the stock market and other asset classes at their core because

Abundance is increasing. They are not zero-sum games. That's episode 432. Thanks for listening.

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