The Game Is Afoot
Updated: Dec 22, 2021
How Game Theory Could Clarify the Investment Past and Shape The Future.
The modern RIA has no shortage of strategies to implement when building the best investment options for their clients. And yet, despite this exhaustive list of strategies, it’s often hard to know which ones will deliver results across diverse investment seasons, complex market swings, and global upturns and downturns.
We consider it our responsibility at UX Wealth to assemble strategies for our RIA clients that help clarify that exhaustive list of options. We do this by focusing on strategies that operate at the intersection of technology and financial advice, that simplify the process for our RIAs, and produce better outcomes for them and their clients.
One of those strategies is game theory.
While the origins of game theory date back almost 500 years, the real advancement and application of it was pioneered in the 1940’s by Jon von Neumann and Oskar Morgenstern – two economists and polymaths who recognized game theory’s radical implications on economics.
As its name implies, it was first used to evaluate games (such as poker or chess). Hence, “game” theory. But now game theory is being applied to other sectors, including:
As it continues to be used and defined and experimented with, game theory is proving to have an incredibly far-reaching potential impact on how we view relationships, and the systems within those relationships which lead to beneficial outcomes.
When it comes to investing, relationships (between people, products, indexes, etc) and beneficial outcomes, cannot be overstated.
But what exactly IS game theory? And how might it bring about the next round of innovations in the RIA field?
What is Game Theory and how do we use it?
Game theory is the act of using mathematics to create a system that models the strategic interaction between two or more parties, in a game, conflict, or environment that has set rules and outcomes.
Using math to maximize your chances of winning in a game that has specific rules (chess or investing) and outcomes (ex. a clear winner\loser).
When it comes to investing through the lens of game theory, we can break it down like this:
The game: Investing.
The participants: Individual investors or investment managers.
Rules of the game: Commonly accepted and trusted beliefs of the participants - such as weathering bear markets, buying and selling during bull markets, taxes are bad, and so forth.
Outcomes\Winning: Returns on investment. Also, positions held, changed, or surrendered by the participants as a direct or indirect result with other participants or the game itself.
Here’s an example of how we apply game theory (using the above) to a scenario:
Our own Ai Funds is powered by a Bayesian learning algorithm. In game theory, a Bayesian game is one in which a decision-making strategy – lacking full details about what the other participant holds – is instead created using the details of past events as well as one’s own holdings. The outcomes are then strategized for or predicted using a probability distribution which accounts for the other participant’s unknown holdings or strategy.
In this way, even without the full knowledge about an opposing participant’s holdings or strategy, a winning strategy is still formulated using mathematics and applying game theory.
Most portfolio managers, presented with the same above scenario, and without the advantage of game theory, become paralyzed or resort to guessing, with no strategy to speak of.
In this scenario, and many others, game theory provides the portfolio manager with credible, data-driven directions when there is no other discernable path to follow.
The future (and past) of game theory's insights on investing and AI
Needless to say, while the intricacies of game theory require more than a casual glance to understand, applied game theory could continue to lead to major breakthroughs for those managing portfolios or creating investment opportunities.
Predicting the future of markets or indexes or downturns is of course impossible. But accurately reading market data, and proactively creating a plan that uses the very best game theory strategies to maximize returns, should be at the forefront of any RIA or investment manager’s toolkit.