Lately I met a friend who is kind of intelligent guy, shared his thoughts why only a few people make good money in stock market while majority lose money, using Pareto theory. This is something I haven't thought off in depth and it triggers me to think through it from another dimension. Here I triy my best to simplify and explain his theory:
Here's how the theory goes with the flow in sequence:
1. Original Pareto Theory says 20% of the people owns 80% of the wealth, which implies to wealth inequality. (I agree with this)
2. Then, people apply it into problem solving approach, where we should only focus on top 20% of root cause which bring 80% of the problems (I agree as well)
3. Then, it is also implemented into corporate world promotional and reward system nowadays. In many MNC's in every annual review 80% of the budget will be rewarded to the top 20% in the form of wage increment and bonus. (kind of agree)
4. Then, it is reflected into stock market or any other investment instrument market. 10% of the top investors profit from 90% of the investors, at the expense of their losses. (Totally agree)
Now we can see the difference between number 3 and 4.
In number 3 (corporate world), the fund comes from the company and distributed to all employees. Even if an employee gets the worst ranking in bottom 10%, the worst case is to get zero increment and zero bonus, but the salary still comes in every month. So there is no losses for any employee.
In number 4 (stock market), the fund comes from capital of every investor, with the intention to draw money from others to his own account. Those who profit are those buy at low price, and sell at high price. He sells at high price to investor who is willing to buy at high price. In this case he is gaining money from the person who is willing to pay more. The person who pays more might later find it difficult to have people willing to buy from him at a higher price. As time passed, he might find more and more people asking to buy at lower and lower price. In the end he might be forced to sell at much lower price due to fund constraint or fear.
Conclusion:
Gainers = buy low from losers, sell high to losers (only minority 10% are willing and capable to do this)
Losers = buy high from gainers, sell low to gainers (most people 90% likes to do this)
Total funds are still the same, just that the $ flows from majority to minority.
No wonder people call stock market as a Zero Sum game.
Indeed, if we factor in brokers who charge commissions for every trade, it should be called a Negative Sum game.
