What is a Zero Sum Game?
A zero sum game is a situation where losses incurred by a player in a transaction result in an equal increase in gains of the opposing player. It is named this way because the net effect after gains and losses on both sides equals zero.
Is the Stock Market a Zero Sum Game?
Investors’ collective performance in the stock market relative to an index is a zero sum game. Since the value of an index includes all gains and losses, it is, by definition, zero sum.
For example, when considering outperforming the market, every outperformance implies an underperformance or loss elsewhere.
However, the entire stock market system should not be thought of as a zero sum game because it does not meet the criteria to be a game with contestants. Only an individual’s performance relative to the stock market index is a game.
What is a Non Zero Sum Game?
A non zero sum game is a situation where there is a net benefit or net loss to the system based on the game’s outcome.
An example of what should be considered a non zero sum game is a contest between a trade ship and a pirate ship, although it may look like one at first glance. Here, a victory for the pirates would mean gains of wealth, resources, and men (probably as prisoners), whereas a win for the trade ship would only mean a defeat of the challenge by the pirates. Here, the prize and losses being different for both the contesting parties do not qualify it as an example of a zero sum game.
Another example could be in financial markets, where competing firms collaborate to expand the overall size of their market. Creating an industry-wide organization would increase confidence in the industry and result in more profit for all competitors.
Non zero sum games don’t have to create a net positive result – it could also be negative as well. In the pirate example above, there is a case where the pirates win, and it’s a net negative for the whole system.
Origin and Importance
The zero sum concept began with the idea that a win could only be attained through the loss of an opponent. The idea was likely born out of an incorrect understanding of economics and finance where the contested entity was considered fixed and unchangeable. Hence, a profit could only be booked by ensuring the loss of competition.
However, the modern understanding of economics broadens the scope, explaining that not all competitions fall into this category. It is possible for all involved contestants to register a win. For example, according to the classical (Ricardian) theory of trade, all parties involved in trade benefit from it.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: