Games people Play. Choose the games you wish to play.

Games people Play. Choose the games you wish to play.

Elaboration of Section 24

This section applies the lens of game theory to investing, providing a powerful framework for understanding the nature of different financial activities and where you, as an intelligent investor, should place your capital. The core message is that your probability of success is heavily influenced by the inherent structure of the "game" you choose to play.

The section categorizes all financial activities into three types of games:

1. Positive-Sum Games (The Investor's Game)

• How it Works: In a positive-sum game, the total size of the prize increases, allowing all participants to theoretically win over time. This happens because wealth is being created.

• The Investing Example: The stock market is a positive-sum game in the long run. Companies produce goods and services, earn profits, and reinvest to grow. This genuine economic growth increases the overall value of the market. When you buy a stock, you are buying a share of a wealth-creating enterprise. The dividends you receive and the long-term price appreciation are your share of this created wealth.

• The Key Insight: As the section states, "wealth is created through the stock market and the evidence is in the issuance of dividends." Your goal is to participate in this wealth creation.

2. Zero-Sum Games (The Speculator's Game)

• How it Works: In a zero-sum game, the total prize is fixed. For one participant to win, another must lose. The net gain of all players equals zero.

• The Investing Example: Trading in derivatives (like options and futures) is a classic zero-sum game. Every dollar made by one trader is a dollar lost by another. There is no underlying wealth creation. Short-term stock trading is also largely a zero-sum game before costs; after accounting for fees and commissions, it often becomes a negative-sum game for the participants as a group.

• The Key Insight: To win consistently in a zero-sum game, you must be better, faster, or more informed than the person on the other side of your trade. It is a game of skill and timing against other participants.

3. Negative-Sum Games (The Gambler's Game)

• How it Works: In a negative-sum game, the total value shrinks because of costs, fees, or the house's take. The aggregate of all players ends up with less than they started with.

• The Investing Example: Casinos are the purest form. The "house edge" guarantees that, collectively, gamblers will lose money. In finance, this can apply to high-fee investment products where the costs are so large they consume any potential profit, or to activities like day trading with high commission costs.

• The Key Insight: The odds are mathematically stacked against you. The section warns that engaging in a negative-sum game over many bets "will surely mean ending the loser."

The Strategic Conclusion: Choosing Your Game
The section provides a clear prescription for the intelligent investor:

• To Win, Choose Positive-Sum Games: Allocate the vast majority of your capital to long-term investing in productive assets (stocks, bonds) where you are participating in economic growth.

• Avoid Negative-Sum Games: Steer clear of activities where the odds are structurally against you from the start.

• Understand Zero-Sum Games: If you choose to speculate (trade derivatives, etc.), do so with a very small portion of your capital, fully aware that you are competing against other players and that it is a difficult way to generate consistent wealth.

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Summary of Section 24

Section 24 uses game theory to argue that the key to successful investing is to consciously choose to play "positive-sum games" where wealth is created, rather than "zero-sum" or "negative-sum games" where you must outsmart others or beat the odds.

• Positive-Sum Game (Investing): Long-term ownership of businesses that create wealth. This is the game the intelligent investor should play.

• Zero-Sum Game (Trading/Speculation): One person's gain is another's loss (e.g., derivatives trading). Requires superior skill to win.

• Negative-Sum Game (Gambling): The system itself extracts value (e.g., casinos, high-fee products). This game should be avoided.

The Ultimate Lesson: You have a choice. By directing your capital into the productive, positive-sum game of long-term business ownership, you align yourself with the forces of economic growth and dramatically increase your odds of financial success. This framework helps you identify and reject speculative and costly activities masquerading as investment. 

This Is More Important Than Investment Profits

By Matt Koppenheffer  
January 11, 2011 

"It's all about making money that's the facts and talk is worthless."

That's the comment one reader left on an article I recently wrote about casino giant Las Vegas Sands (NYSE: LVS). Based on the available information, I argued that there wasn't a compelling case for buying Sands at today's price (just more than $50 as of this writing). The commenter in question disagreed with me, saying that we'd know who was right based on where the stock price finishes the year. After all, the comment implies, if you can't judge investing prowess based on profits, then how can you judge it?

The argument is compelling on the face. Certainly, every investor aims to make money with her or his investments. However, when it comes any particular investment, is the profit or loss that's banked really the best way to judge success or failure?

A lap around the track


Let's take the discussion to the horse track for a moment. One bettor at the track lays his money on SmartyBet, whose odds are listed on the tote board as 30-to-1, but who we know (with our hypothetical preternatural insight) has a 20-to-1 chance of actually winning. Meanwhile, another bettor puts money down on WayOverbet, a horse paying 3-to-1 whose actual odds of winning are 5-to-1.

The race is run, and WayOverbet ends up winning by a nose, paying our second bettor $3. Was that a good bet?

If all we care about is profit, then we'd say yes -- after all, that bettor has $3 instead of $1 in his pocket, while the other has a lonely spot in his wallet where a dollar used to be. But if both of these bettors make these same bets over the course of 100 races, it becomes quite clear who the smarter player is. Our first bettor will end up winning five of those 100 races, each paying $30, for a total of $150. The second better will win much more often, showing a "profit" 20 times out of the 100 races, but each will only pay $3, leaving him with just $60 for his $100 worth of bets.

Obviously, the most important thing here wasn't to show a "profit" on a given bet, but rather to make sure that each bet was smart -- that is, one that had better actual odds than what the tote board showed.

Process versus outcome


Probably the best discussion that I've seen about this issue comes from Michael Mauboussin's book More Than You Know. Tellingly, it's the very first chapter of the book, and it opens with this quote from Robert Rubin:

Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

Mauboussin emphasizes the point, writing:

... investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field -- such as investing, sports-team management, and parimutuel betting -- all emphasize process over outcome.

Winning the process game


Mauboussin very clearly lays out what the ideal goal of any investment process should be:

The goal of an investment process is unambiguous: to identify gaps between a company's stock price and its expected value. Expected value, in turn, is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes.

What does this mean in practical terms? I often begin my investment research using a screen that identifies stocks with certain attributes. For our purposes here, let's say I'm looking for stocks that are currently out of favor with investors, so I set a screen looking for any stock that has declined by 20% or more over the past year and is currently trading at less than its tangible book value. Here are a few of the companies that pop up:

Company	Year-Over-Year Price Change	Price-to-Tangible Book Value
Banner Corp (Nasdaq: BANR)	(23.7%)	0.6
K-SEA Transportation Partners(NYSE: KSP)	(61.4%)	0.4
Oilsands Quest (NYSE: BQI)	(59.0%)	0.4
Hercules Offshore (Nasdaq:HERO)	(38.1%)	0.4
American National Insurance(Nasdaq: ANAT)	(26.5%)	0.6

Source: Capital IQ, a Standard & Poor's company.

To follow good process in evaluating these stocks, I'd first try to identify possible outcomes for them, and what those outcomes would mean for the stock price. Washington-state-based Banner, for instance, traded at more than twice its tangible book value prior to the financial crisis, so we could probably envision a case where shares recover to three or four times their current value. American National Insurance, meanwhile, has had cyclical valuation swings that have typically put its tangible book value multiple in a range of 0.5 to just above 1.0. In a scenario where toxic assets don't eat away at the balance sheet and investment returns start to increase, investors could see real upside here, too.

Of course, we also need to consider negative outcomes, as well. For example, investors would want to note that Oilsands Quest has never reported an annual profit. There may be a huge upside if the company finds a way to profitability, but its assets may not be worth all that much if it can only produce losses. Similarly, driller Hercules Offshore has been trying to find its footing again, but the need for a balance-sheet-strengthening capital raise may impact the value of currently outstanding shares.

Once you have a list of the potential outcomes for the stock in question, you can then weigh the potential for each of those outcomes to come to fruition, and end up with a good sense of whether the stock is a worthwhile investment.

The year-end review


Any one of these stocks -- Las Vegas Sands included -- may end the year with a higher or lower price than what the ticker tape shows right now. But the best investors won't spend all of their time focusing on whether there was a profit or loss -- but rather on evaluating whether the decision-making that led to the investment was sound.

The comment that I highlighted at the beginning concluded that "talk is worthless." Perhaps talk that focuses simply on the outcomes of investments is worthless. But I think few things are more valuable than talk that discusses potential investment outcomes and helps hone process.

http://www.fool.com/investing/general/2011/01/11/this-is-more-important-than-investment-profits.aspx

Reposting on Investment, speculation and gambling (Security Analysis, Ben Graham.)

It is commonly thought that investment, is good for everybody and at all times. Speculation, on the other hand, may be good or bad, depending on the conditions and the person who speculates. It should be essential, therefore, for anyone engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justifiable one.


Investment, speculation and gambling(Security Analysis, Ben Graham.):

1. Graham defined investment thus: An INVESTMENT OPERATION is one which, upon THOROUGH ANALYSIS, promises SAFETY OF PRINCIPAL and a SATISFACTORY RETURN. Operations NOT meeting these requirements are speculative.
The difference between investment and speculation, when the two are thus opposed, is understood in a general way by nearly everyone; but it can be difficult to formulate it precisely. In fact something can be said for the cynic's definition that an investment is a successful speculation and a speculation is an unsuccessful investment. The failure properly to distinguish between investment and speculation was in large measure responsible for the market excesses and calamities that ensued, as well as, for much continuing confusion in the ideas and policies of would-be investors.


2. Graham's addition criterion of investment: An investment operation is one that can be justified on BOTH QUALITATIVE and QUANTITATIVE grounds.
Investment must always consider the PRICE as well as the QUALITY of the security.



Main points:______________

INVESTMENT OPERATION: rather than an issue or a purchase.

PRICE: is frequently an essential element, so that a stock (and even a bond) may have investment merit at one price level but not at another.

DIVERSIFICATION: An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly.

ARBITRAGE AND HEDGING: it is also proper to consider as investment operations certain types of arbitrage and hedging commitments whichinvolve the sale of one security against the purchase of another. In these rather specialised operations the element of SAFETY is provided by the combination of purchase and sale.


THOROUGH ANALYSIS: the study of the facts in the light ofestablished standards of safety and value, including all quality of thoroughness.


SAFETY: The SAFETY sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experiences indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.


SATISFACTORY RETURN: is a wider expression than "adequate income", since it allows for capital appreciation or profit as well as current interest or dividend yield. "Satisfactory" is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

_______________


For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly – and often soundly – derive its basis and its justification from prospective developments that differ from past performances.

GAMBLING: represents the creation of risks not previously existing – e.g. race-track betting.

SPECULATION: applies to the taking of risks that are implicit in a situation and so must be taken.

INTELLIGENT SPECULATION: the taking of a risk that appears justified after careful weighing of the pros and cons.

UNINTELLIGENT SPECULATION: risk taking without adequate study of the situation.

Capitalism is not a zero-sum game

Except for a few crooks, the rich do not get that way by making other people poor.

When the rich get richer, the poor get richer as well. 

If it were really true that the rich get richer at the expense of the poor, then since the US is the richest country in the world, by now, they would have created the most desperate class of poor people on earth.  Instead, they have done jsut the opposite.

There is substantial poverty in America, but it doesn't come close to matching the poverty seen in parts of India, Latin America, Afria, Asia, or Eastern Europe where capitalism is just beginning to take hold. 

When companies succeed and become more profitable, it means more jobs and less poverty.

Games people play

Essentially, there are 3 types of games people can play. These are:

1. Positive sum games
2. Negative sum games
3. Zero sum games

In positive sum games, the odds of winning are high and there are many winners.

In negative sum games, the odds of losing are high and there are many losers.

In zero sum games, the odds of winning equal those of losing, the winners are at the expense of the losers.

It is important to choose the games one wishes to play. It is very important to know the types of games one chooses to play in.

To win, choose the one in the category of the positive sum game.

Avoid playing in those negative sum games. For those wishing to "win" (try their luck or gamble) in negative sum games, their best chance of coming out the "winner" is probably just to place ONE bet with the amount they can afford to risk and hope for a lucky win. To be engaged in such a negative sum game over many bets will surely mean ending the loser.

What about zero sum games? How to be the winner here? Often, the player with the most capital wins in the long run. This is because the player maybe struck with a string of bad luck and the player with the least capital may be out of capital earlier than the player with more capital.

To be a winner, choose the games one wishes to play in carefully. Investing is likewise not dissimilar. One need to have the investing knowledge before "playing this game" intelligently, lest one ends up not winning but losing.