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. 

Investments and Risk Reward Ratio

It is always interesting that there are so many different types of investments around us, ranging from regulated investments such as bonds and stocks, all the way to unregulated investment vehicles such as collectibles, antiques and many others. In this post, I’m slightly more inclined to talk about some common investments, mainly money markets, bonds, stocks and derivatives as well as their risk-reward relationships. To illustrate this, let’s start with a picture.

I do hope that the picture is pretty clearcut. Basically, it says that the higher the return, the higher the risk. Note that in the picture, derivatives has lower return, but higher risk and I will explain why it is so in the picture. I am actually taking into account expected rewards, which is different from potential rewards. Potential rewards mean the high end spectrum of what is achievable, whereas expected rewards basically mean the aggregate returns of all investors who participate in the investing of the instrument.

Now, after having explained my definition, let’s look at the investments and their risk rewards ratio. It is seen from the diagram that for taking more risk, the expected rewards is greater, with the exception of derivatives. The explanation is that derivatives are theoretically zero sum games, which means that when someone makes money, another has to lose it. After commissions, spreads and other charges, they are practically negative sum games.

I have friends who said that stock markets are negative sum games too, because the same principle applies. However, they missed an important point, which is the fact that wealth is created through the stock market and the evidence is in the issuance of dividends. For example, I bought a stock at $10 and sell it for $9.50. I may seem to have lost money, but what if I got a dividend payout of $1.00 while holding the stock? From this example, we can see that the purchase of stocks is not a zero sum game and that the general direction of the stock market in the long run is an uptrend. Of course, I am assuming that there is no large scale war or natural disaster that will destroy a significant amount of wealth. Even if there is though, wealth will be recreated as long as humans survived.

Just like stocks, bonds and money markets are also both not zero sum games, since there is an effective yield that you can get. While some of them may default their payments, we are looking at the aggregate of all investments in the instrument, which makes it a positive sum game.

For derivatives though, it is a clear cut zero sum game, because there is absolutely no payouts linked to the instrument. You don’t get dividends for holding options or futures. However, I would like to argue from another standpoint that perhaps it is not really that much of a zero sum game. The reason I would like to input this perspective is the prevalence of people who like to hedge their investments. Therefore, they may have holdings of stocks and buying options to offset the downside. Hedging in such a way often gives them an effective yield almost equilvalent to the risk-free rate. Therefore, they may not care if their derivative products lose money, since their overall portfolio gives them the desired return that they want.

This seems to get quite complicated, but I am suggesting that if there are really quite a number of hedgers out there in the financial world, it is possible that they are all holding the derivatives that lose money. Consequently, this may mean that it may be slightly easier to profit from derivatives than a strict zero sum game, since some people participate in the game without the intention of winning. Of course, if we aggregate all the positions, we are still back to a strict zero sum game. 

However, my purpose in this post is only to bring about another perspective that perhaps not everybody wants to make money from every market. Some people may participate in some markets and lose constantly but still persist because they satisfy them in some other way. Therefore, it may mean that for those who are serious about making money in the markets, the chances are slightly higher. After all, it is easier to win in a race against leisure runners than national runners who are committed to getting that next medal.

Of course, with everything said, it’s just my hypothesis and it may or may not be right. 

http://www.firstmillionchallenge.com/investments-and-risk-reward-ratio/


This article was first posted on 24.11.2011.

Investments and Risk Reward Ratio

It is always interesting that there are so many different types of investments around us, ranging from regulated investments such as bonds and stocks, all the way to unregulated investment vehicles such as collectibles, antiques and many others. In this post, I’m slightly more inclined to talk about some common investments, mainly money markets, bonds, stocks and derivatives as well as their risk-reward relationships. To illustrate this, let’s start with a picture.

I do hope that the picture is pretty clearcut. Basically, it says that the higher the return, the higher the risk. Note that in the picture, derivatives has lower return, but higher risk and I will explain why it is so in the picture. I am actually taking into account expected rewards, which is different from potential rewards. Potential rewards mean the high end spectrum of what is achievable, whereas expected rewards basically mean the aggregate returns of all investors who participate in the investing of the instrument.

Now, after having explained my definition, let’s look at the investments and their risk rewards ratio. It is seen from the diagram that for taking more risk, the expected rewards is greater, with the exception of derivatives. The explanation is that derivatives are theoretically zero sum games, which means that when someone makes money, another has to lose it. After commissions, spreads and other charges, they are practically negative sum games.

I have friends who said that stock markets are negative sum games too, because the same principle applies. 

However, they missed an important point, which is the fact that wealth is created through the stock market and the evidence is in the issuance of dividends. For example, I bought a stock at $10 and sell it for $9.50. I may seem to have lost money, but what if I got a dividend payout of $1.00 while holding the stock? From this example, we can see that the purchase of stocks is not a zero sum game and that the general direction of the stock market in the long run is an uptrend. Of course, I am assuming that there is no large scale war or natural disaster that will destroy a significant amount of wealth. Even if there is though, wealth will be recreated as long as humans survived.

Just like stocks, bonds and money markets are also both not zero sum games, since there is an effective yield that you can get. While some of them may default their payments, we are looking at the aggregate of all investments in the instrument, which makes it a positive sum game.

For derivatives though, it is a clear cut zero sum game, because there is absolutely no payouts linked to the instrument. You don’t get dividends for holding options or futures. However, I would like to argue from another standpoint that perhaps it is not really that much of a zero sum game. The reason I would like to input this perspective is the prevalence of people who like to hedge their investments. Therefore, they may have holdings of stocks and buying options to offset the downside. Hedging in such a way often gives them an effective yield almost equilvalent to the risk-free rate. Therefore, they may not care if their derivative products lose money, since their overall portfolio gives them the desired return that they want.

This seems to get quite complicated, but I am suggesting that if there are really quite a number of hedgers out there in the financial world, it is possible that they are all holding the derivatives that lose money. Consequently, this may mean that it may be slightly easier to profit from derivatives than a strict zero sum game, since some people participate in the game without the intention of winning. Of course, if we aggregate all the positions, we are still back to a strict zero sum game. 

However, my purpose in this post is only to bring about another perspective that perhaps not everybody wants to make money from every market. Some people may participate in some markets and lose constantly but still persist because they satisfy them in some other way. Therefore, it may mean that for those who are serious about making money in the markets, the chances are slightly higher. After all, it is easier to win in a race against leisure runners than national runners who are committed to getting that next medal.

Of course, with everything said, it’s just my hypothesis and it may or may not be right. 

http://www.firstmillionchallenge.com/investments-and-risk-reward-ratio/

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.