Behavioral Finance
By Christopher M. Uhl
Game theory is the mathematical study of strategy involving two or more rational contestants (who can be either cooperative or non-cooperative), each with multiple choices or sequences of choices. In modern use, the term “game theory” has become something of a catch-all phrase for the science of logical decision-making, but it’s worth questioning how logical people’s actions actually are.
It’s nearly impossible to talk about game theory without mentioning mathematician and Nobel Prize winner John Nash, famous for the Nash equilibrium and portrayed by Russell Crowe in the 1998 film A Beautiful mind. He proposed that when no player can increase their expected return by changing strategies while all others’ strategies remain constant, then equilibrium is achieved (this video has a quick introduction with examples). However, both the Nash equilibrium and later Rationalizability (Bernheim & Pearce) require rational participants.
It is possible to simultaneously have a completely rational desired outcome – to “win,” or in the case of investing to capture a greater return – while also taking irrational measures to achieve that goal, like a military victory attributed to doing what the enemy never expected. Have you ever watched people playing tic-tac-toe, and one of the players makes an obviously foolish move? What about situations where the obviously foolish move still resulted in – perhaps even fundamentally caused – victory?
Not every game is as simple as tic-tac-toe. When interacting with markets, the logical, rational choice is seldom readily apparent, and as we’ve already explored, participants are frequently hindered by an assortment of cognitive biases. These biases are left to fill the voids created by the lack of a clearly preferable option, influencing outcomes tick-by-tick, day-by-day, year after year, even if you make no changes to your portfolio, because even inaction is a choice.
