Game Theory

To design a killer portfolio you must understand Game Theory

The stock market isn't a game, but understanding game theory will help you design an efficient portfolio. An efficient portfolio is one that moves you towards your ultimate goal as quickly as possible, given the amount of time you have and the amount of risk you can handle.

Let's say you're in your 30's and just beginning to accumulate enough savings to require a serious portfolio design. You look at the market and think "This should be pretty easy. Just buy the stocks that are going up and don't buy the ones that are going down. Easy-peasy."

Well, it's not that simple. The stocks you like that have been going up have been going up because lots of other investors have the same idea you have. They're growing like crazy and the sky's the limit. Why not jump on board? 

Because of the irrefutable rule of game theory that once everyone is invested there are no more buyers left to drive the price higher. But there are plenty of sellers waiting in the wings to sell the stock at the first sign of trouble.

And so, the company continues to make more and more money but not at the same pace as they once did. Bullish investors begin to question how much more upside there is, and begin to pull back on their positions. The shorts have a field day, riding the stock all the way back down to "fair value" which is a lot lower than the peak price. 

The Keyensian Beauty Contest

The strategic interaction of all investors trying to figure out how all other investors feel about a stock, or the future direction of the stock market, with each of them knowing that everyone else is going through the same decision process, is the essence of The Keynesian Beauty Contest.

In 1935, economist John Maynard Keynes described the investing game as a “Newspaper Beauty Contest”, which was a media promotion that was familiar to his readers. This was the heyday of the Miss America pageant and “bathing beauty” contests were everywhere. Here’s how Keynes described it.

A newspaper published the photographs of a group of pretty girls, and readers were invited to mail in a ballot with their choice of the prettiest face. If you picked the girl who got the most votes, you were entered into a drawing for some sort of prize. Voting for the girl you think is the prettiest is what Keynes would call the first degree of decision-making.

After a few tries, you realize that choosing the girl who you believe is the prettiest is not a winning strategy. To win, you need to choose the girl who gets the most votes and so your task now becomes figuring out who everyone else is going to vote for. Voting for the girl that you expect more people will vote for is what Keynes would call the second degree of decision-making.

But there’s a problem with the second degree. It assumes that everyone else is basing their choice on their personal preference of the photographs, and you’re the only one smart enough to think about the average preference of the group. So you now realize that everyone will be thinking like you are, and therefore you need to make a third-degree decision – who will get the most votes when all the voters are basing their votes on who they think will get the most votes? This is the nature of the investing game.

To get beyond the third degree of decision-making requires a superior identification of whatever it is that “everyone knows”. 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.”

The question now becomes how do we practice the fourth, fifth and higher degrees of decision-making? How do we identify the context and strength of what “everyone knows”? How do we win the investing game?

That's what this course is all about.