Watching the market this year has been like observing an exercise in game theory and behavioral finance, and the two fields are closely related. Game theory is the study of how a rational person makes decisions in uncertain situations. As the name suggests, game theory was developed with the intent of developing optimal strategies in games in which chance or the decisions of an opponent play a role in your outcome. Game theory focuses on how rational players can make the best decisions to maximize their satisfaction. Behavioral finance adds the nuance that, in real life, people do not necessarily have all available information and, even if they do, they often make decisions that are inconsistent with those made by a perfectly-rational and fully-informed decision maker.
There is a huge literature of both game theory applied to financial decisions and behavioral finance. I am going to discuss a select sample of the really striking manifestations and why they matter.
Notice that in my description of game theory, I write that people act to maximize their satisfaction rather than their returns or their wealth. Investors' sources of satisfaction may differ. Some people like the excitement that comes with a chance at a huge win, even if the statistics show that their odds of winning are not good. Other people, knowing the odds of winning, are more inclined to seek a bet with a high probability of winning, even if the size of the win is not all that great.
The games on Wall Street come in a variety of forms. We have investors buying and selling from each other. We have fund managers who seek to demonstrate that they have the ability to generate market-beating returns and thereby to attract investors. We have research firms that tell investors that if they just have the right charting tool, they can beat the odds. We also have venture capital firms that seek to rapidly grow out small companies and reap high returns by taking these companies public to great fanfare. A less well-known game occurs between shareholders and corporate management. While management is supposed to act on behalf of shareholders, there are ways that management can (and often do) enrich themselves at the expense of shareholders. Finally, recent research suggests that in making their savings decisions, people act as though they are competing for consumption with a future self who they really can't envision or relate to.
While the launch and subsequent collapse of a number of web-based software companies has the public's attention today (Groupon, Zynga, etc.) we very recently experienced a very similar event in the 'green tech' bubble in which the hot stocks were those of companies that produced solar panels and other clean energy products (FSLR, STP, YGE). At the end of 2007, First Solar (NASDAQ:FSLR) sported a P/E of 178 and the stock went on to exceed $300 per share in 2008. Today, the stock trades at about $22. How is it possible that investors so quickly forget the last disaster and just move on to the next?
In this five-part series of posts, I will explore a number of the challenges that investors face from the perspective of game theory and behavioral finance. In part 2, I start with a discussion of how Wall Street provides investors with what they buy rather than what they need. In addition, I explore some of the inherent conflicts of interest (so-called agency problems) that investors must come to grips with.Related Links:
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