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Negative Sum Investing Theory

>> Saturday, November 21, 2009

Recently read an interesting story that I would like to share:

Once upon a time, a large family owned all the shares of the top companies in the market. They just held on to their shares without doing anything. As the companies of the underlying shares made profit, they received dividends. Some more than others but nobody lost. (There was no capital appreciation as there was no trading done to determine price.)

Then one fine day, some discontented people decided that they wanted to trade shares with others for what they felt were better companies. So, they engaged a middleman to go around finding those who wanted to sell/exchange their shares for a negotiated price. Each time a trade was successful, the middleman took a percentage of the price.

After trading for some time, some were happy as they indeed got the better companies, however, some were worse off as the company they traded for performed worse. So, the discontented ones decided to engage analyst to help determine which are the better companies. The analyst charged a fee of course (PhD holders do not come cheap).

Believing in their analyst (people with PhD can't be wrong, right?), they traded more. As time went on, those analyst that were correct, were paid more. And soon, everyone was looking for their own analyst and trading a lot based on their recommendations (more commissions for the trader too).

Some felt it was very time consuming to work with their analyst and trader all the time, so they decided to engage a manager to do all the management on their behalf. Again, for a fee of course. At any point in time, definitely there were some managers which performed well and they were highly remunerated, but all were remunerated nonetheless.

Now as time when on, there was so much choices and it was mind boggling to handle all the information and selection. So, some decided to engage a consultant to make sense of everything and recommend a good manager for them. Again, for a fee of course.

Soon, they realized, only a small minority of the family had the good fortune to make profits while the family as a whole were worse off.

Unknowingly, they have turned a positive sum game to a negative sum game for themselves! And created a new positive sum game for Mr Trader, Mr Analyst, Mr Manager and Mr Consultant!

Moral of the story/My comments:

1. Mr Trader, Mr Analyst, Mr Manager and Mr Consultant are all very profitable because it is a sure win game for them! Mr Trader is happy so long as you trade and pay his commission; Mr Analyst is happy to analyze and write reports so long as you read and pay for them; Mr Manager is happy so long as you pay for the fund management service; Mr Consultant is happy so long as you pay for his advice and recommendations.

2. Is their value add worth the amount you are paying? How many funds performed better than the index?

3. They should fire all these people which didn't exist in the first place. Pull all their shares together and divide the profits among themselves equally. Back to an all win state. That is the exact purpose of an index fund.

It is my humble opinion that investing already involves risk. By adding more variables of selecting the above mentioned people increases the risk. And in fact paying for the additional risk! It makes absolutely no sense.

No doubt that you may be in the minority that are actually better off. But the question will be, how consistently will you be better off? Unless you know what you are doing, I would recommend that the most efficient passive management technique is to practice dollar cost averaging into a good index fund or ETF.

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