Game Theory as it applies to Investing in the Stock Market

Game Theory as it applies to Investing in the Stock Market


“To be nobody-but-yourself — in a world which is doing its best, night and day, to make you everybody else — means to fight the hardest battle which any human being can fight.”
- e.e. cummings

Investing is not a game. But in some respects, it is a game. There is a goal, there are rules, and there is a way to tell whether or not you succeed. And, as we shall see, there are strategies for success that come right out of Parker Brothers.

Here is the game:

1) The name of the game is investing in the stock market.

2) The object of the game is to make as much money as you can without suffering material adverse effects on your standard of living.

3) Players start with limited amounts of capital, making decisions to buy and sell stocks.

4) Players who lose their money are eliminated from the game.

Here are the considerations that will form the basis of our strategy:

1) In playing the game, we will employ our experience and ability to reason. If we utilize them well, we expect to have an edge, that is, an advantage in playing the game.

We recognize that the markets are efficient at many things and therefore, it is difficult to obtain an edge and all the more so if we are going to act like everybody else. Therefore to have an edge we must strive to think and act differently from the rest of the market.

2) The nature of the game is such that our edge notwithstanding, the outcome of any particular purchase is highly uncertain.

The markets are a social process and, therefore we are dealing with a largely imponderable phenomenon. We also recognize that the world is full of surprises and that anything can happen to us at any time. Any number of random occurrences may intervene to disrupt the outcome within the time horizon we operate in. We can lose because we were wrong. We can lose because we were unlucky. However, the uncertainty that creates aversion is the same that creates opportunity.

3) There is a direct relationship between the risk we take and the amount of reward we receive when events go in our favour. There is also a direct relationship between the risk we take and the likelihood that we will be eliminated.

We can manipulate our risk by adjusting the amount of capital we place at risk on a particular investment or series of investments and by adjusting our strategies (choosing among those that have a higher probability of success but provide a smaller reward and those which have a more remote likelihood of developing in our favour but that reward us most handsomely when they do.

Prime Directive: Never do anything that is attended by the risk of elimination (don’t let them kick you out of the game!).

Resources

The Speculator's Edge
Albert Peter Pacelli