Fundamental value is an inexorable tide that pulls on the price of markets and currencies over longer-term time horizons. While the calculation of fundamental value is still necessary as an investment tool, it’s no longer sufficient in and of itself.
This is especially true in today’s geopolitically unstable world, which, unlike the Cold War era, comprises a plethora of overlapping game theaters, such as the eurozone crisis, periodic U.S. debt ceiling negotiations, and the perpetual conflict in the Middle East.
Applying game theory to investing can help. Here’s how our Dynamic Allocation Strategies team uses game theoretical constructs to identify, quantify, and analyze these global macro forces.
With game theory, we improve the organization and interpretation of information, and that means we’re more likely to discern truth than see what we want to see.
1. Assess Initial Conditions
We begin by determining the objectives and dimensions of net influence for each player. Understanding their cultures, interests, incentives, and powers helps us understand their potential actions and reactions. That’s not to say this allows us to predict specific actions or outcomes, but it does add to our understanding of potential displays of power, especially brinkmanship maneuvers that are particularly troubling to market participants.
We then position our portfolios to potentially benefit from or protect against these displays of power.
2. Adjust Risk Exposures Based on Players’ Actions and Reactions
As players act and react, we shift portfolio exposures in an attempt to benefit from market misinterpretation. Misunderstanding of the negotiating process, especially when it gives rise to the deliberate creation of risk, can lead to unwarranted panic or euphoria. This creates short-term opportunities, so we modify the timing and magnitude of investment positions, seeking to benefit from the inevitable medium- and long-term reversion of market and currency prices to fundamental values.
3. Gauge Discrepancies During the Negotiating Process
At each step of the negotiating process, we evaluate fundamental opportunities to gauge whether they afford adequate compensation for the risk the negotiation presents over the coming weeks, months, or even years. If our understanding of the negotiation is sufficient, risk is adequately compensated, and strategies are consistent with our fundamental value signals, we position our portfolios to take advantage of the opportunity or to eliminate the risk.
Game theory doesn’t eliminate risk. The soul of strategic negotiation is risk, created and responded to by players who are human and, thus, fallible.
But, with game theory, we improve the organization and interpretation of information, and that means we’re more likely to discern truth than see what we want to see.
If you’re looking for an easy-to-understand example of many of the principles of game theory, read my recent post: Rocky, Bullwinkle, and Game Theory.