Investing Made Simple: Part 1 - The Zero-Sum Game
The thing about investing is that there are always two sides to every trade, e.g. in order for one to buy something, another has to be willing to sell something at an agreed price. This creates an interesting dynamic, because the one buying thinks the price will go up, whereas the one selling thinks that getting rid of things at this price is a good idea. There are mitigating circumstances of course, e.g. sometimes people have to sell because they need the money, or some other force majeure means one side has to trade no matter what the price. But under normal circumstances, how exactly do you reach a price at which a trade is settled?
In the financial markets, the process of price discovery is driven by supply and demand on an exchange, whereby people who want to buy things put in prices (Bid) at which they would be willing to acquire a set amount of goods (e.g. shares, bonds, currencies or others). The people who want to sell something put in prices (Ask), at which they are willing to part with a set amount of goods. This creates a deep matrix of different quantities and prices at which different people are willing to trade their goods. What separates the two sides from one another is the so-called “Bid-Ask spread” and it can be as narrow as a few basis points (e.g. 0.01%), or very wide (e.g. >1.00%) if there is a dearth of potential buyers and sellers. For most, this spread doesn’t matter much. After all, prices are always moving and if you are going to buy Vodafone, do you really care if you got the shares at 219.5 or 220? Particularly when set against the expectation of a significant price increase, why else buy in the first place. But as we all know, every little helps, and if you perform many trades and you consistently buy on the Ask or sell on the Bid, it will have a significant impact on your gains at some point.
So, in a lot of ways, this spread is sort of like the front line in the daily battles between buyers and sellers as they settle on a fair price. And it does give a perfect illustration of how professional investors deal with finding an acceptable price when both parties know what they are doing. By that we mean that either party wants to keep these little differences to work in their favor. So, imagine the scenario, you have master of the universe 1 trying to buy as cheaply as possible and you have master of the universe 2 trying to sell as high as possible. There is bluffing going on with putting in fake large orders on one side, so as to make the other party think that the supply and demand dynamic has changed. There is also a lot information being disseminated, as the positive and negative sides of the investments are articulated and there are thousands of other buyers and sellers, all doing their thing to find the best price.
So where do most professional traders settle in the end? Right in the middle it turns out, and it kind of has to if you think about it. Akin to playing Connect-3, if both sides know what they are doing, there can be no winner (this was well established in that ground-breaking science fiction movie ‘War Games” (1993), whereby the super computer had to be convinced that nuclear war will only have losers, if both sides play the game to its logical conclusion). And therein also lies the lesson for every investor: for every winner, there has to be a loser. But for every trade, there is always a fair value.