Stock Market EV

[hmkpoker]

How is investing in the stock market +EV? I view the following as true (please correct me if I'm wrong):

1) The market is an almost-zero-sum game. Corporate earnings influence the values of stocks (which hurt or help everyone alike), but because most stocks have phenomenally high P/E ratios, the market is essentially zero sum.

2) Because it is zero-sum, you are competing against others in a game of odds. This includes people who have inside information, and therefore have a better edge of when to buy and sell. (I figure this would be like playing poker with people who are much better than you...and the broker's fees are like a rake!)

So how can stock trading be +EV?

Your first assumption is wrong. The market is a positive-sum game. Corporate earnings will continue to increase over time (or at least they have for the past 400 years) at a rate of around 10% per year. This will eventually be reflected in share prices and dividends.

Based on PE ratios, you may think that stock prices won't reflect increased earnings in the middle term, but this is hardly ironclad. It's just as probable that PE ratios will remain constant, meaning increased earnings will cause increased share prices. Over a 20 or 30 year horizon, you can be fairly certain that the market as a whole will beat inflation and short-term interest rates.

[Sniper]

You really should read thru other recent posts... this forum does not get too much traffic to make this impossible to do.

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1) The market is an almost-zero-sum game.

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No it is not... the stock market is in no way a zero sum game!

Very simple example... 4 players...
Player A has $10, Player B has $10, Player C has $10, Player D has $36, Total wealth in system = 10+10+10+36= 66

Players A,B and C all buy 1 share of stock for $10.
Then Player D buys 1 share of stock from Player A for $11, 1 share of stock from player B for $12, and 1 share of stock from Player C for $13...

Now... player A has $11, Player B has $12, Player C has $13, and Player D has 3 shares of stock worth $39, Total wealth in system = 11+12+13+39 = 75

Note that Everyone is ahead... Player A +1, Player B +2, Player C +3, Player D +3.

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So how can stock trading be +EV?

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Because someone who knows nothing about investing can stick their money in an index fund and earn roughly +10%/yr compounded. In the stock market ALL players can be big winners.

ok... so how is this possible... several reasons, but the easiest way to understand this might be, because the true value of a stock is based on factors outside the stock market system.

A comparison to poker would be if the value of the chips on the table increased while you were playing and you could cash in your $25 chip for $50 cash.

[hmkpoker]

(I'm sorry that this is such a dumb question!)

Why does Player D have 3 shares worth $39? (Presumably at $13/share)

If this is the case, haven't players A, B and C all earned +$3, since the value of their stock is now $13?

[Sniper]

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Why does Player D have 3 shares worth $39? (Presumably at $13/share)

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The value of a share is generally qouted as last trade value. (yes 13x3=39, sry if that wasn't clear)

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If this is the case, haven't players A, B and C all earned +$3, since the value of their stock is now $13?

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Because Player D bought Player A,B& C's shares...
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Then Player D buys 1 share of stock from Player A for $11, 1 share of stock from player B for $12, and 1 share of stock from Player C for $13...

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[hmkpoker]

This seems really, really wrong.

If it's correct, then why can't four people assemble in a like fashion and make tons of money?

[Unabridged]

the market isn't zero sum because its a pyramid scheme. always fresh cash entering the market, just like poker

[hmkpoker]

money is being withdrawn too.

I usually post in the MTT forums cause that's what I play as a hobby, but I thought I might as well post here after reading this post.

A quick background. I am a day and swing trader, I have made my living for the past 4 years doing so.

Anyways, to the question. If you have read Alexander Elder's books, he has an entire chapter on this. The Stock Market is not a Zero-Sum game, it is less than that. Brokerage commissions and SEC fees make it a losing venture unless you have an edge. This is why most traders lose. My first 9 months of trading was very difficult because I was paying my "trader's tuition" as Elder calls it. I was learning by losing. You are taking into account the fundamental aspect of the market which is, in my and many trader's opinions, irrelevant. For example, Qualcomm (QCOM) has a track record of beating the street and reporting phenomenal earnings. One earnings release QCOM beat by 15% but despite these huge numbers the stock dropped 6%. The market is based on psychology and this psychology is reflected in the charts. In the extreme long run inflation increases and the market goes up and investors seem to make money. However the Real Return (inflation adjusted return) is around flat. Therefore, (successful) traders have an enormous advantage over investors.

Another thing, your average 40-something investor who invests for retirement is putting money in stocks which he things will increase in value. Uninformed people like this don't realize that stocks include intrinsic future value. Lets say you buy Google (GOOG) because you think it has huge potential. Well guess what, so does everyone else. This potential "potential" is already factored into the stock price. Same goes for the earnings in the QCOM example earlier.

Just my 2¢

-Chris

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However the Real Return (inflation adjusted return) is around flat.

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No. Look at Figure 3 on this page. (http://www.finfacts.com/stockperf.htm) Stocks outpaced inflation by 5.5% in the last 100 years in the UK. It was 6.9% in the US between 1926 and 2001. This is based on an increase in intrinsic value following expanding businesses and growing profits.

Good luck with the trading. Have you stopped paying tuition yet?

[adios]

The stock market is not zero sum for a few simple reasons:

1 - It's easily proven mathematically that individual company risk can be "diversified away" by selecting a group of stocks.

2 - Investors are compensated for taking risk in stocks by a "risk premium" that is over and above the amount of the risk free rate of return. The ex ante value of this risk premium is open to debate. The ex post value of the risk premium is certainly above the risk free rate of return.

The stock market has never had a 20 year period where the value of the market failed to appreciate. Very few 10 year periods. If I buy an index fund or SPY and hold it for 20 years and the value increases who's losing? Nobody that I know of.

[Sniper]

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If it's correct, then why can't four people assemble in a like fashion and make tons of money?

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First, my example was very simplified, in order to illustrate the concept.

Second, People do this every day!

[Sniper]

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If you have read Alexander Elder's books, he has an entire chapter on this.

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Which of his books and what chapter?

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The Stock Market is not a Zero-Sum game, it is less than that. Brokerage commissions and SEC fees make it a losing venture unless you have an edge. This is why most traders lose.

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When you started trading 4 years ago, many unknowledgable Day trader wannabees lost alot of money because they were clueless fish eaten up by the professional market maker sharks. This says nothing about zero sum howver, just that they were losers in a +EV game.

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If you have read Alexander Elder's books, he has an entire chapter on this.

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Which of his books and what chapter?

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"Come into my trading room"
Very first chapter

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[ QUOTE ]
The Stock Market is not a Zero-Sum game, it is less than that. Brokerage commissions and SEC fees make it a losing venture unless you have an edge. This is why most traders lose.

[/ QUOTE ]

When you started trading 4 years ago, many unknowledgable Day trader wannabees lost alot of money because they were clueless fish eaten up by the professional market maker sharks. This says nothing about zero sum howver, just that they were losers in a +EV game.

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"Market maker sharks?" Please read the first chapter of "Come into my trading room" if you don't believe my argument because I don't want to sound like I'm repeating myself.

-Chris

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However the Real Return (inflation adjusted return) is around flat.

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No. Look at Figure 3 on this page. (http://www.finfacts.com/stockperf.htm) Stocks outpaced inflation by 5.5% in the last 100 years in the UK. It was 6.9% in the US between 1926 and 2001. This is based on an increase in intrinsic value following expanding businesses and growing profits.

Good luck with the trading. Have you stopped paying tuition yet?

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Nice chart, I stand corrected. I'm sure there are many theories on why this happens but maybe it has to do with something as overlooked as population growth and more money from more people coming into the market. However, I don't want to speculate because I am unfamiliar with those theories.

And yes, I have stopped paying my "trader's tuition." It took me about a year which is apparently early according to Elder.

-Chris

[hmkpoker]

No, I think you misunderstand.

I mean that if I (with $36) and three of my friends, each with $10, sit in a room together with our money and "trade," then no matter what we identify as shares or how we trade, there is still going to be $66 total in that room.

We can only profit if money comes from somewhere else.

[hmkpoker]

This is more or less exactly as I envisioned the stock market to function.

I'll see if I can find that book.

[Sniper]

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I mean that if I (with $36) and three of my friends, each with $10, sit in a room together with our money and "trade," then no matter what we identify as shares or how we trade, there is still going to be $66 total in that room.

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But you are not trading $$$ in the stock market, you are trading pieces of paper (shares of stock)... who's value changes!

You wouldn't trade a Babe Ruth mint condition rookie baseball card, for a random 2005 baseball card would you? They are after all both a single baseball card!!

[Sniper]

Hi Chris & welcome to the forum,

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"Come into my trading room" Very first chapter


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Care to quote where Elder talks about the stock market as a zero sum game?

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"Market maker sharks?" Please read the first chapter of "Come into my trading room" if you don't believe my argument because I don't want to sound like I'm repeating myself.

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I am very familiar with Elder and highly recommend his books!

I'm still not sure what your "argument" is, as Elder does not talk about the stock market as a zero sum game!

[Sniper]

In fact, you can listen to Elder's intro to his book in his own words (http://www.elder.com/Sound/intro.mp3) (click link to listen)

[hmkpoker]

That's not the point. Four people in the isolated system can't generate more money than they already have. The money has to come from somewhere else. Their benefit has to come at the loss of someone else. This is why I think it resembles a zero-sum game (or negative-sum game like poker)

I did say the stock market is NOT a zero-sum game. I'm not saying it is!

-Chris

[hmkpoker]

I'd like to point out that I was never asserting that the stock market is a zero-sum game; only that it manifests some of the PROPERTIES of a 0sg. Poker is negative sum, but one's profits always come necessarily at the losses of someone else in a proportional manner.

The stock market, I recognise, is even further removed from this model, because the company's profits and losses introduce an element that can be beneficial or detrimental to all.

However I would sharply contrast the stock market with a genuinely non-zero sum like, say, the basic economy, where what benefits one often benefits others.

Page 6-7 from "Trading for a living," not "Come into my trading room" I don't feel like typing out 2 pages of copyrighted text into this form either. But here it is on amazon:

http://www.amazon.com/gp/reader/0471592242/ref=sib_rdr_prev2_fm13/104-6938277-8603163?%5Fencoding=UTF8&keywords=zero-sum&p=S00L&twc=4&checkSum=6iUdGYRx6rvfcQ7%2Bdkr1YY QUcyjINbZ%2FIK2TC9rqKx8%3D#reader-page

-Chris

[Sniper]

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That's not the point. Four people in the isolated system can't generate more money than they already have. The money has to come from somewhere else. Their benefit has to come at the loss of someone else. This is why I think it resembles a zero-sum game (or negative-sum game like poker)

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You are right that the players can't generate more money... an intrinsic value change from outside the system creates the wealth... which is exactly why its a non zero sum game!

The value of the commodity being traded changed and all owners of the commodity benefit from the change in value.

To add to the example... assume a 5th player (lets call him a long term investor) ... he bought a share of stock when it was $5... his share is also now worth $13.

The benefit does not come from a loss to anyone else... this is one of the reasons that the stock market is the greatest wealth builder in the world!

[Sniper]

Chris,

This is what you said...
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If you have read Alexander Elder's books, he has an entire chapter on this. The Stock Market is not a Zero-Sum game, it is less than that. Brokerage commissions and SEC fees make it a losing venture unless you have an edge. This is why most traders lose.

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Maybe I'm just not understanding what you were trying to say...

Could you please explain what you mean by the market being less than a zero sum game? (and how that relates back to anything in Elders book)

The market is a minus-sum game. You buy 100 shares of XYZ at $10, you pay $1010 including a $10 comission. You sell those same shares at $10. $(1000 - 10 ) - 1010 = -$20

That isn't even including SEC fees. You bought and sold your stock at the same price so you should be even, right? Wrong, you are down, therefore the market is a minus-sum game. This is exactly what Elder states if you read that link. I'm not even including slippage in this argument as I don't want to get above peoples' heads.

-Chris

[squiffy]

The pie is not fixed at a constant size. The pie is constantly growing.

That's like saying the population of the U.S. is zero sum. The stock market is NOT a game involving 52 cards in a deck.

.....fiat money supply

[Sniper]

Chris,

commissions are part of the system... that wealth is not destroyed, it is simply shuffled to another player, in this case your broker. In the long run, the entire system is a positive sum game because wealth is created (by factors outside the system).

[DesertCat]

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However the Real Return (inflation adjusted return) is around flat.

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No. Look at Figure 3 on this page. (http://www.finfacts.com/stockperf.htm) Stocks outpaced inflation by 5.5% in the last 100 years in the UK. It was 6.9% in the US between 1926 and 2001. This is based on an increase in intrinsic value following expanding businesses and growing profits.

Good luck with the trading. Have you stopped paying tuition yet?

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Nice chart, I stand corrected. I'm sure there are many theories on why this happens but maybe it has to do with something as overlooked as population growth and more money from more people coming into the market. However, I don't want to speculate because I am unfamiliar with those theories.

And yes, I have stopped paying my "trader's tuition." It took me about a year which is apparently early according to Elder.

-Chris

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I think you (and Elder) are confusing "the market" with "trading". Long term the prices in the stock market are basically set by earnings, which typically grow over time. Any index fund will track the market with minimal cost, providing a roughly 10% annualized return over long periods.

Review the average earnings of the S&P500 for the last 50 years and you'll see why the index has increased in value. And that value doesn't even include all the dividends paid out over those years.

So the "stock market" is +EV about 10% per year (not adjusting for inflation). "Trading" can be a negative EV activity if you are only "right" half the time because frictional costs (i.e commission) from rapid trading would tend to overwhelm gains from appreciation.

Example. Let's say you trade 200 days per year. Your frictional costs are 15/100 of one percent per day. Over 200 days that costs you 30%, triple what you can expect in even a typical year from appreciation. I.e. you need a +30% annualized trading strategy just to pay your commissions.

Of course, if you have an intelligent approach (such as Arbitrage) you can be right much more than 50% of the time.

[Bosox]

Read "a random walk down wallstreet" by i think dan malikiel (the name is likely wrong). it's educational and surprisingly interesting. it's also a well read book within the field and not bad for beginners.