At its core, game theory is the study of human decision making within a competitive environment. Perhaps even more simply put, game theory is the science of strategy with the goal of determining both the best and non-optimal decisions in a given situation. Further, the word “game” is deceptive to some as they assume it refers only to recreational games. While it is true that game theory can be applied to such games, more broadly, it references any situation whereby independent groups (or individuals) share a set of “rules” and “consequences.”
As mentioned above, game theory can be applied to nearly all competitive situations — including investing. Moreover, to effectively describe how this is true, we will look at poker strategy and how it aligns with the mechanics of investing tactics. Poker provides a good comparison as you are competing with other players in the same way that investors compete against one another. For example, an opponent might have better information than you, a larger bank roll, or more skill/experience in either “game.” Similarly, both games share the ultimate goal of avoiding the loss of your own capital and patiently waiting for the right opportunities to win big. Additionally, just like poker, investing is a zero-sum game. For those who may be unfamiliar, a zero-sum game is a game during which one person’s gain is equivalent to another player’s loss – meaning there is a net change of zero. Furthermore, a zero-sum game can include only two players, or millions. That said, there are not many million-player poker games, however, there are millions of investors on earth that you may be competing with. Keep in mind, every time you buy a stock, there is another person (or group) on the other side of your trade. Essentially, you are betting against each other based off your opinion as to whether the stock’s price will rise or fall. In the end, you cannot both be right and one player will win while the other loses.
Like poker, and other games that can be analyzed using game theory, there are better and worse ways to invest (play the game). Consequently, investors (players) with a well-documented investment plan, as well as the high level of self-discipline needed to stick to it, tend to perform better. For instance, if an investor chooses to allocate half of their portfolio to stocks in a specific company (or industry) and receives news leading to the belief that it will take an economic turn for the worse, they might decide to sell. According to game theory, their best next move might be to immediately buy stock in another industry (or company) that benefits from the crash of the original stock in question. As result, the investor would continue to hold the same allocation of stocks they originally planned for — and possibly avoid taking a loss. This scenario is a potential real life example, however, in a perfect world (with perfect information) there would be a definitive “best strategy” that could be solved for using backwards induction.
The process of backwards induction revolves around the ability to start at the end of a problem (scenario/game) and determine which decisions result in the most optimal strategy for each player. Since it starts with the final step of the game, it is not realistic in real life scenarios that are happening in real time, as it requires hindsight to perform. That said, backward induction is extremely important because it can be used as a learning tool to aid in predicting the decisions that competitors will make in the future. Since it is unlikely that you can see into the future — and use backward induction to build your portfolio today based off of decisions that will be made tomorrow — it could be a great idea to study investment decisions that professionals have made in the past when facing similar circumstances to yours. Doing this will not guarantee that you will make the perfect choice every time, but it will help to provide more context when you do make choices. Overall, using game theory as a supplementary tool for financial analysis could be the next step you take as you learn to navigate real world “games!”