You may have heard of the ‘prisoner’s dilemma’. It’s a standard example in a branch of economics called ‘game theory’.
I studied it at university.
To be honest, it was the one branch of economics I thought was actually as near to reality as you and I experience it.
And when you’re investing, it’s a crucial framework. Because it describes what you have to do as an investor every day. Namely, to make decisions in a world of uncertainty. But crucially, game theory acknowledges that the decisions of others also affect you directly.
And it shows why groups of ‘rational’ individuals might result in poor outcomes for all.
I think you can see where this is heading…
Whether you want to buy property, invest in the booming stock markets, or buy some cryptocurrencies, the outcome is partly going to rely on the behaviour of others.
I’ll come back to this soon.
But first, let’s look at the classic prisoner’s dilemma game.
And then we can apply that thinking to investing.
The optimal decisions for individuals may surprise you.
What would you do?
Renowned mathematician John von Neumann pioneered the concept of game theory in 1944.
John Nash came along a few years later and applied deep mathematics to game theory, a story told in the film A Beautiful Mind, starring Russell Crowe.
The concept of ‘Nash equilibrium’ describes the optimal situation where no participant has an incentive to change their choice.
The classical example of game theory is the prisoner’s dilemma game.
Consider you and a friend are under suspicion for a crime. The police are interrogating you both in separate jail cells.
You have two options: confess or don’t confess.
If you both confess, you both go to jail for 10 years.
If only one confesses and the other doesn’t, he only gets one year, while the non-confessor gets 25 years in jail.
If neither of you confesses, you each get three years in jail.
What do you do?
The optimal decision, as it turns out, is for both to confess.
The risk of not confessing and relying on the other to do the same is too great (Nash proved this mathematically).
But as you will also see, it’s not the optimal outcome.
If you could somehow slip a note to your friend and tell them not to confess, you’d both only get three years each instead of 10.
Which brings us to the investor’s dilemma today.
Take the prospect of buying a property.
A young couple may reasonably assume that, in an era of record low interest rates, high wages-to-house-price ratios, and low wage growth, the optimal decision for them is to wait a few years for house prices to normalise.
Now, if everyone else did that, then that’s probably what would occur.
Interest rates would have room to rise without stifling the economy too much, the heat would come off the housing market as demand dropped, and prices would return to more normal relative levels.
But the opposite happens if everyone else continues to pile into property.
With a highly-indebted population, the RBA has less room to move on interest rates, prices remain high as demand keeps pushing prices up, buyers compete with investors over price, and the cycle of price rises continues.
The ‘sensible’ decision to stay out of such a frothy market costs you.
Of course, an economic shock might hit at a later time. But that’s external to the decision-making model we discuss here.
The Nash equilibrium here is to buy a house!
You could repeat this for booming stock markets and for cryptocurrencies and get the same outcome.
Though, of course, each market has its own complexities to account for and make the decision realistic.
But the house purchase decision is pretty close to reality right now.
Life is a game
The classical models of economics taught in universities have proven to be poor models of reality.
Game theory injects the realism required for useful analysis of decision-making processes.
As you can see, it explains why buying into a boom can be a perfectly rational decision. Even if the consequences aren’t.
Cryptocurrencies are a speculative asset class where this theory also holds.
A bitcoin buyer today relies on what the future decision of others will be.
And this will remain the case at least until the technology starts to provide tangible systems to deliver on their promise.
The timeline for that breakthrough moment (or moments) is uncertain.
But I think when you understand the real innovation taking place, it’s also inevitable.
And the potential gains are spectacular.
So here’s a game for you…
You can invest $100 in cryptocurrencies now.
If everyone else decides to invest and hold, in 10 years’ time, it might be worth $1,000, $10,000, or even more.
Or, if no one decides to invest — or everyone decides to sell — it will probably be worth close to zero.
The decision is yours…
Editor, Exponential Stock Investor
Editor’s Note: This article was originally published in Money Morning.