How Game Theory Applies to Investing
How game theory principles from poker apply to markets and investing.
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As I spend more time investing, I notice many striking parallels between the decision-making process I use in poker, and the ways it applies to markets.
Two Unique Approaches to Investing
In poker, there are two approaches which are diametric opposites. The first, we’ll call Type 1, is old school and uses an exploitative approach. The professional first observes the tendencies of his or her opponent, and comes up with counter strategies to outwit them.
For example, should he observe that his opponent folds too often, the professional adjusts by bluffing more.
The second (Type 2) uses game theory, and has come to be known as a ‘game theory optimal’ (GTO) approach.
The GTO pro studies Nash equilibrium strategies to come up with optimal solutions for each decision, based on the underlying assumption that his or her opponent will also study these solutions, and therefore that the only way to win is to play optimally based on the theory and math.
GTO believes in loss minimization, whereas exploitative play aims to maximize wins. GTO advocates believe that theory is needed to win in a more competitive poker landscape, and that since others are using game theory, the only way to stay competitive is to ‘outplay’ others by having a more balanced game with optimal solutions for every move their opponent makes.
Critics complain that GTO players don’t take into account the human element, as game theory does not make adjustments based on player type, mood, emotion or history. It simply plays its cards based on the math, every single time.
While the Type 1 exploitative approach is more of an art, the Type 2 game theory approach is more of a science.
Game Theory and Investing
It seems to me that these two diametric approaches exist in capital markets too. Some traders look at market sentiment and, when they notice the vast majority of the market is positioned in one direction, they bet on the opposite. These are your ‘Type 1’ exploitative players.
The fear and greed index is a common way to measure this, and many believe it’s a key indicator for predicting markets. For example, during the Covid lows in March, the fear index was near an all time high. Savvy investors realized this was likely the bottom, as most were already bearish. With few marginal sellers and a ton of capital on the sidelines, they went long and made a fortune.
The ‘Type 2’, game theory players focus on fundamentals and are less concerned with market psychology. Warren Buffett is one of the most famous value investors of our time. He famously claims that Mr. Market will always pipe his head up and spit out prices, often irrationally, but the savvy investors job is to sit back and wait for the right price. Then, you go all in.
Type 2 investors aren’t concerned with market sentiment. If something is over valued, they don’t touch it, regardless of how the market is positioned.
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The Best Investing Approach
The obvious question is, which approach is superior? One commonality between poker and investing is that vicious advocates on both sides will die on the hill trying to convince you why their approach (religion?) will produce superior returns. I’ll leave it to them.
I believe in both poker and investing, there is merit on both sides. Just like a poker player must master his preflop play and fundamentals, in markets one must first understand the underlying fundamentals.
Is this asset overvalued or undervalued?
Why?
What macro factors or other conditions would cause it to move one way or another?
This is the science of investing.
Armed with this theoretical understanding, one can now explore the artistic side and determine if there is room to maximize returns through some exploitative play.
Is the setup right for this asset to move right now?
What is the market sentiment behind this trade?
What are the media and pundits saying?
One lesson I’ve learned time and again in crypto is current narratives often trump underlying fundamentals, especially in the short term. Shitcoins and mediocre projects with great marketing often outperform great projects with no marketing.
Put another way, you don’t want to be alone in a forest with a tree falling and betting on it making a thunderous sound.
The Current Macro Landscape
As I’ve written about in The Future of Money, the average market participant is far from taking a game theory optimal approach toward investing. I believe if they were, people would store their wealth in Bitcoin and not fiat. Eventually we’ll collectively get there, but we clearly have a ways to go. This will produce the greatest wealth transfer in the history of mankind.
Right now, I believe the stock market is fundamentally over valued, and the ‘everything bubble’ should ultimately burst, but in the short term we have periods where we are oversold, and therefore I temporarily speculate long despite being in a bear market trend.
While I believe Bitcoin is dramatically undervalued long term, in the short term I began calling for a bearish setup nearly a year ago. As a response, I decided to play the Type 1 exploitative play and move mostly into cash in hopes of exploiting the markets ignorance about money, hard assets, fiat currency and ultimately, Bitcoin becoming a global store of value.
In short, I often trade based on Type 1 because I love the game and dare to venture that I have an edge. I am obsessed with the process, and love learning and iterating until I get it right.
I believe most would benefit from a Type 2 approach. That is, being a value investor, making fewer trades, and avoiding the temptation to get involved and exploit the market, but rather focus on preserving wealth and spending their time doing more of what earned them the money in the first place.
What type of investor are you?
Alec