The zero-sum connection

In our most recent post, we outlined some significant developments investors should be aware of, developments that will likely initiate a paradigm shift not just in technology-related industries but also in many other areas of life.

As professional portfolio managers, we would be foolish to publicly share such specific ideas on a blog -- or even outline some of the specific underlying fundamentals and critical metrics used in our investment philosophy -- if active money management were indeed all about the "ability to predict consistently the appearance of new information" and use it to advantage before others do, as efficient market theorists describe it (the quotation cited here to describe active management comes, in fact, from Eugene Fama's famous 1964 dissertation which was the founding document of the efficient market hypothesis; published in the January 1965 Journal of Business, citation is from page 40).

In other words, if money management were only about exploiting temporary inefficiencies in the market before other people noticed those inefficiencies (as passive management advocates say that it is, in their arguments against active management), then it would be foolish for any money manager to ever publish a blog!

This important point reveals that the world-view of the advocate of passive investing is, generally speaking, a zero-sum world-view (we discuss the zero-sum concept in several previous posts, such as this one). He believes that the only way to outperform the market is to exploit some superior information before others do so (a zero-sum outlook).

He then arrives at the superiority of passive investing (such as indexing) by a similar zero-sum argument: since efficiencies are quickly reduced, no one can consistently "beat the market." Therefore, returns are basically a fixed pie (the return of the market), and in this zero-sum world, the best thing to do is get as much of that fixed pie as possible (by owning the market for the lowest fee possible). You can see that this is exactly the line of argument presented by index-fund magnate John Bogle in his 1994 book, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor.

But it is a false premise to assert that the totality of the market (all existing publicly-traded businesses) is the limit of what an investor can achieve. Some businesses are well-run businesses in front of fertile fields of growth; others are poorly-run, and others are operating in fields that are dying out or contracting. Even an indexing advocate would have to admit that he could, with the benefit of hindsight, assemble a portfolio that would deliver returns far in excess of the total market, if you asked him to select thirty or forty superior companies at any given time over the past ten years, even if you told him he had to hold each company that he chose for not less than three years. This exercise alone proves that the returns of the total market are not the fixed pie of returns which all investors must squabble over, as the zero-sum world-view would have you believe.

Mr. Bogle, in fact, has explicitly stated his zero-sum view of the world in many statements since then, such as his statement that "The market as a whole is simply a gambling casino where investors as a whole try vainly to outpace the market. Beating the market is a zero-sum game, but only before costs are deducted" ("The Wall Street Casino," 1999). More recently, he told a graduating class from Georgetown's McDonough School of Business that "we're no longer making anything in this country, we're merely trading pieces of paper, swapping stocks and bonds back and forth with one another" -- a starkly zero-sum view of the American economy, and one that is patently incorrect (from speech delivered May 17, 2007).

In contrast, the classic growth stock theory of investing that forms the foundation of the investment management we advocate takes a profoundly positive-sum view of business and investing (true investing, as opposed to speculation or gambling). We believe that good businesses add new value into the system that was not there before, and that the history of the growth of the American economy in general and the history of specific companies over the past hundred years is so full of examples that support this assertion that it is hard to argue otherwise.

The exponential growth in the U.S. GDP (for example, from $9.6 trillion in 2000 to over $14 trillion today) is not simply a result of more vigorous "swapping stocks and bonds back and forth with one another" but rather is the result of real value being created by real businesses. Our investment philosophy of building wealth on the foundation of the ownership of well-run businesses operating in fertile fields of growth is based on the recognition of this undeniable fact, and on the recognition that most real wealth in this country has come from the ownership of a company or companies which produced real value for a number of years.

The passive investment argument, by all accounts including those of its adherents, did not arise in the business world or in the world of money management, but rather in the world of academia. For a variety of reasons, this is understandable. The academic arguments in support of it rely heavily on mathematical demonstrations -- and mathematical formulas are almost by definition "zero-sum" (what is added to one side of a formula must be subtracted from the other: an equation is a closed system in this sense). Furthermore, the tenure system is itself a sort of zero-sum system, in which only a certain number of professors can hold tenure at any given time, and for one to be added another must generally leave. While many mistakenly believe that this is the same way that the business world operates, the reality is actually the opposite in a free market economy (for a more thorough discussion of this subject, see this previous post and the article linked in the post).

The connections between the passive investment arguments and the zero-sum world-view are not widely understood, but they are very important.

for later blog posts dealing with this same subject, see also:

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