How ‘Game Theory’ Can Make You a Smarter Investor

  • Posted By :
  • Tuesday Nov 07, 2017

Key Takeaways

Game Theory can impact investing behavior for the better

  • What is the stock market as Game Theory sees it?
  • First, second and third-level decision-making, as per J.M. Keynes
  • Recommended reading

Game Theory studies “the conflict and cooperation between intelligent rational decision-makers” in behavioral relations. Popularized hugely by the film ‘A Beautiful Mind’, many of us have heard the term, but do not think much about its application in day to day to life. Let’s look at how Game Theory can guide your investing behavior.

  • In Game Theory terms, the stock market represents a multi-player, zero sum game against nature and sentiment. A classic example is J.M. Keynes fictional newspaper contest from his work, ‘The General Theory of Employment, Interest and Money (1936)’, to explain price fluctuations in equity markets. In it, participants are asked to pick the 6 most attractive faces from 100 photographs. The winners would be those who picked the most attractive faces.

  • The first level of decision-making in such a scenario would involve each participant voting for the faces they (and they alone) think is the prettiest. But, the winning strategy would be to choose the pictures that everyone else thinks are the most attractive. So, now you’re voting for the pictures you think the most number of other participants will find attractive. This is the second level of decision-making. However, this assumes that everyone else (except you) is making a first-level decision based purely on their preference.

  • This is however far from reality. Because you are in fact, making a third-level decision, i.e. which pictures will get the most votes, when all voters are basing their votes on who they think the most people will vote for. Or, as Keynes wrote, “We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

  • Confused? THIS is how stock market sentiments work. Also, note that the third-level of decision making has nothing to do anymore with the actual merits of the faces and features in the photographs. Decisions by traders are taken under a combination of risk, uncertainty and imperfect market knowledge across traders.

  • So, while Game Theory mathematical models may not perfectly explain market behavior all the time, Game Theory knowledge and appreciation allows for a better structured risk assessment, esp. for short term trades. Even if you don’t go for a full-on academic immersion into Game Theory, some reading would be a worthwhile use of your time (and money)

Essentially, every time in life you need to act on a pricing strategy, consider the factors guiding those around you. See if communication with other players is an option, to try and discover the optimum output of the ‘game’ through cooperation. See if you can assess what the dominant strategy of the other players could be, and decide accordingly. If nothing else, your basic understanding of game theory will at least help you structure your thinking better than the average punter guided by first-level sentiments.

Important Links

Roger Myerson (Game Theory: Analysis of Conflict, Harvard University Press, 1991)

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