Important facts for Investment Managers and Traders

stock market trading

Important facts for Investment Managers and Traders

Investing is a zero-sum game

Investing is a zero-sum game when performance is measured relative to the value-weighted market index. The aggregate gains of all investors who beat the market are exactly equal to the aggregate losses of all investors who underperform the market.

This equality follows from the fact that all securities are owned by someone. Accordingly, the average return to holding all securities in the market (the return to the value-weighted market index) must equal the value-weighted return of all investment portfolios formed from those securities. If some investors beat the market, others must underperform.

Because investors incur transaction costs when they trade, investing— especially active investing—is a negative-sum game. Controlling transaction costs thus is essential for investors who seek to beat the market. Of course, all traders who want to preserve or grow their capital must control transaction costs, regardless of how they benchmark their performance.

Investment managers concerned about beating their peers should consider the following fact: Among large blend equity mutual funds, only 87 bps separate the return performance of the 40th percentile fund from that of the 60th percentile fund in the distribution of annualized total five-year returns.1 Poor traders can lose that much in transaction costs during the course of a year, especially if they trade frequently.

The observation that trading is a zero-sum game (or a negative-sum game when transaction costs are included) has an extremely important implication for active investment managers who base their trading decisions on financial analyses.

Those managers who regularly under-perform the market do not do so because they systematically choose the wrong securities to hold in their portfolios. Such managers could easily adjust their trading strategies to simply do the opposite of whatever their analyses suggest and thereby beat the market. The financial analyses of under-performing managers thus are not systematically wrong.

Instead, they are systematically uninformative—sometimes they are right and sometimes they are wrong

About Author

Related posts

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.