If you’ve spent any time studying the stock market and investment, you’ve likely encountered the idea that investing shares many fundamental principles with game theory. As explained by Born2Invest, game theory is essentially “the study of mathematical models of conflict and cooperation between intelligent rational decision-makers” – it underlies every major decision we make in life, particularly when there are two parties with intersecting or competing interests. That’s why, by studying activities more directly linked to game theory, such as betting or game shows, investors can learn valuable skills that can improve their outcomes.
How we talk about investment
One of the first elements that indicates that we think about investing similarly to gambling is just how we talk about it. Investors bet on an outcome or analysts “beat” a company based on earnings predictions. The language is that of games, and just as gamblers assess certain conditions – for example, the stakes on a horse or the most likely outcome of a card hand based on what’s in play – investors do the same thing. They look at analyst reports, past earnings, market trends and economic conditions. Investors may not speak in terms of game theory, but they’re engaging with it.
At the races
Investors may be using game theory, but in order to maximize the insights derived from it, it helps to look at specific applications, so let’s take horse wagering as an example. Whether at the track or at an OTB parlor, those betting on horses look at several specific factors to determine their chance of winning, and of winning big. In each race, horses are given odds based on how likely they are to win, and the worse their odds, the greater the potential earnings. However, long odds also indicate an unlikely outcome, so investors have to balance that information when making a choice.
This brief description quickly reveals how similar betting on horses is to investing in stocks. A likely winner – think, a stock like Apple – is going to be more expensive to invest in, and while it will likely grow, you’re unlikely to gain much, at least not proportionally. Less expensive, potentially more volatile stocks, on the other hand, promise a greater return, but that return is less certain. And like odds on horses, stocks are assigned price/earnings ratios that indicate relative value, and those P/E values can also be used to compare a stock’s current performance to its historical patterns.
Game Show Strategy
It’s not just horse racing that can offer insights into investment strategies. Game shows can also be enlightening. Consider how James Holzhauer recently dominated Jeopardy by breaking the traditional risk-taking model. Instead, he played using a strategy that can be described as optimization, which is essentially just making the best use of resources. Rather than building up towards harder questions, then, Holzhauer would consistently take risks on hard questions first to build his pot, allowing him to wager more on Daily Doubles early in the game. Other players have historically played easy questions first to build confidence and maintain control, but Holzhauer demonstrated the benefits of eschewing that strategy.
To optimize an investment portfolio, you would take a similar approach to investing as Holzhauer took to playing Jeopardy. If, for example, you’re trying to save for retirement, it’s okay to take more extreme risks earlier in your life so that, even if you lose, you have time to earn your funds back. Meanwhile, when facing two similar funds or stocks, choosing the one with a slightly greater price-earnings ratio will optimize your portfolio by increasing your overall earnings potential.
It’s all ddds
Whether you’re playing blackjack or poker or investing in the stock market, the fact is that it’s all odds and game theory that can help you navigate that space. Your goal is to assess the conditions surrounding that risk, how much you can afford to lose in a worst-case scenario, and to understand your own level of risk aversion. Some people are okay with bigger risks, but you have to play it smart. Do your research and learn the theory underlying your investments. Viewing it as a game can help make investing more fun and open up new approaches, but always remember that it’s a game with real ramifications.
Disclosure: I do not own any of the stocks mentioned.
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