Friday, January 30, 2015

Zero-Sum Games

While sports is not a subject that's covered much on this blog, I'll use the upcoming Super Bowl -- with consideration for the amount of betting on the event that will occur in mind -- as a convenient excuse to revisit some of the differences between gambling, speculation, and investment.

Naturally, a variety of bets will be placed on that big game. Also, plenty of bets were made on game outcomes and individual player performance (through, for example, various forms of fantasy football) during the regular football season. On occasion, I'll hear someone suggest that owning stocks is just another form of gambling. Well, it certainly can be turned into gambling -- or a gambling-like activity -- but it need not be. It all comes down to behavior. Those who trade rather frequently are doing what, at least to me, is effectively gambling. There's nothing inherently wrong with that approach other than too often it tends to be not all that lucrative.

In fact, what happens to a stock over short amounts of time is essentially a coin flip. The price action of a stock is moved in the near-term by the voting machine. The price level in the long run is set, within a range, by the weighing machine. In the short run it's a popularity contest; in the long run it mostly comes down to what something is intrinsically worth.

Now let's say, for example, someone participated in fantasy football league and ended up winning 7-8 times their money that was put at risk.
(Over the course of the regular football season.)

That's a nice rate of return by any standard, right?

It would be tough to match that by owning common stocks -- other than , maybe, the most speculative variety -- even with some leverage involved (e.g. via margin or equity options).

Yet such an impressive return can't viewed in a vacuum.

First, the fact is it's likely that all or a good chunk of that money put at risk in the sports bet could be permanently lost. In contrast, that can be a much lower probability outcome with, for example, a quality common stock that's bought well (i.e. plain discount to a conservative estimate of value) and owned for a very long time.

A sports bet -- or any bet -- is generally a zero-sum outcome. The reward comes at the expense of at least one other person.*

A good investment is -- or should be  -- very different. Capital certainly can and does get permanently lost with equity investments but, with a sound overall approach, the probability of it happening can be much reduced (over the long haul relative to typical pure zero-sum bets).

The value of a dollar bill will not increase in purchasing power over time. Well, at least that's the case if history is any guide. The fact is, especially over the very long run, most currencies tend to decline in purchasing power rather substantially. For a business -- whether owned outright or via common stock -- this need not be the case. Good businesses, unlike dollar bills, can intrinsically increase in value especially over the longer haul. They do so because, through their competitive advantages, quality businesses can profitably produce something of value year after year at an attractive rate of return on capital.** A business that is financially sound with a strong at least sustainable (though ideally improving) competitive position has the potential to generate attractive returns for quite some time.

So a key difference is investment can provide an outcome that is not zero-sum:

"...stocks grow in value over time because they retain earnings and they expand basically the companies underneath you." - Warren Buffett on CNBC

Those retained earnings may or may not be put to good use but, at least with capable management in place, it's unlikely the cash that's generated is being thrown into a furnace (though sometimes dumb capital expenditures and acquisitions act as a functional equivalent to this behavior). The earnings from a business with durable advantages should directly benefit long-term owners (via dividends and buybacks) or be of indirect benefit as the retained earnings are put to work (on hopefully what are high return investments) with an eye toward the longer term.

If two people put $ 100 each into a bet with each other then the winner walks away with $ 200 and the other walks away with, well, nothing.

Zero sum.

One winner.

One loser.

Much like the big football game this weekend.

If the same two people put $ 100 each into an investment that doubles in value both end up with $ 200. Both win.

Of course, it's also possible, unlike the bet, that they could have both ended up with a loss.

Now, an investment generally require much longer time horizons than a bet. Think decades. So they mostly will just not produce lottery ticket like outcomes. For those stocks that do happen to produce quick and spectacular returns, the risk of permanent loss was likely very high.

A big part of the challenge is minimizing the possibility of capital being permanently lost while still generating an attractive return. Risk and reward need not be positively correlated. Temporary paper losses are acceptable; permanent losses are not. Mistakes will inevitably be made but, when you can minimize the big losers then the winning decisions usually take care of things.

So returns need to be viewed in the context of the possibility of permanent capital loss. Most forms of gambling fail miserably in this regard. Gambling might provide some entertainment but, otherwise, it has little in common with investment.

I'd rather do something that's not such a zero-sum game. If I invest in equities – the businesses are growing; for example, Wrigley's will make more gum. It's automatically working for me, even if I do nothing. But if I invest in currencies, it's not working for me. - Charlie Munger at the 2005 Wesco Annual Meeting

Speculation and gambling are similar in many ways yet they are not the same:

"...I would distinguish between speculative and gambling. Gambling involves, in my view, the creation of a risk where no risk need be created." - Warren Buffett at the FCIC

Buffett contrasts pure gambling -- the taking on of risk that need not be taken on -- with someone who plants a crop early in the year, now has locked in expenses, and needs to speculate on what commodity prices will be late in the year.

The possible price fluctuation represents a real risk that already exists and needs to be managed. That kind of speculation is necessary and very important.

Lions, leopards, and house cats have some similarities but the differences matter.

Gambling, speculation, and investment might also have some similarities but the differences matter.

Investing well requires, among other things, figuring out what something is conservatively worth then buying when the discount becomes meaningful. A margin of safety is what protects against the unexpected and mistakes.

Buying a dollar bill for 50 cents makes permanent capital loss rather a lot less likely. The same goes for buying all or part of a good business at a 50% discount to intrinsic value (again, conservatively estimated) especially since there's the potential for increases to value.

Along the way market prices may fluctuate quite a bit but that, in itself, doesn't necessarily make the asset risky.

Adam

Related posts:
On Speculation and Investment
Bogle on the Financial System
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

* For simplicity, I'm ignoring frictional costs here though many forms of gambling have huge frictional costs. So it's actually a negative-sum game for the participants putting money at risk (though not for the croupier).
** High returns on capital beats growth for its own sake. Businesses with exciting growth prospects understandably get plenty of attention. The question is (or should be) whether that growth can be achieved in a way that is beneficial to owners. Durable high returns on capital -- whether growing quickly or not -- is what matters. Growth can certainly be a good thing; it's just not inevitably a good thing.
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