When we use game theory to understand geopolitical developments (e.g., the Middle East, the U.S. presidential election, Brexit ) that may drive the price of an investment toward or away from its fundamental value, we look at the “dimensions of net influence” that each player brings to the table—the powers and abilities, both tangible and intangible, used to exert control over other players.

In our experience, these dimensions of net influence tend to coalesce around four characteristics—endowment power, coalition power, risk tolerance, and salience—that help us determine the potency of players’ negotiating strategies.

Game theory provides a way for us to better organize and process the vast amount of information that affects global economies and markets.

Endowment Power

What it is: An initial resource base

What to watch for: Confidence, aggression

Example: During the Cuban Missile Crisis, President Kennedy relinquished old nuclear missiles in Turkey as a quid pro quo for Nikita Khrushchev’s withdrawal of Cuban-based nuclear missiles. Absent the endowment of missiles in Turkey, Kennedy would have been without an important source of bargaining power. Similarly, today, North Korea’s Kim Jong-un benefits from the possession of nuclear warheads.

Coalition Power

What it is: The ability to form and alter coalitions to augment the effectiveness of a negotiating strategy

What to watch for: Solidarity, adaptability

Example: In World War II, the Allied Powers coalition was constantly evolving, including at times France, the United Kingdom, the United States, the Soviet Union, and others in the many fronts opposing the Axis Powers of Germany, Italy, and Japan. A more recent example is “Merkozy,” the unlikely cooperation between Angela Merkel and Nicolas Sarkozy in an attempt to preserve the European Union.

Risk Tolerance

What it is: The willingness to take collateral risk of large magnitude or to have negotiations break down without resolution

What to watch for: Bluffs, disinterest, eleventh-hour resolution

Example: President Kennedy privately estimated that the Cuban Missile Crisis increased the risk of broad nuclear confrontation between the Soviet Block and the United States from a 30% to 50% probability.

Salience

What it is: How important the negotiation is to each player

What to watch for: Degree of engagement in theater (which is highly correlated with salience)

Example: Austerity reductions are very salient to Greece

Dimensions of Net Influence Today

The chart below shows the objectives and powers we attributed to key eurozone players in the first half of 2015. This period was one of heightened geopolitical risks driven mostly by conflicting primary objectives between Greece and Germany. These two players had mutual incentive to step closer to the brink of “Grexit” in pursuit of their objectives than they otherwise would.

The outcome of the negotiations between Greece and the rest of the eurozone also had broader implications for the region as populism was spreading to countries such as France and Spain, whose primary objective had become to push back against this populist ascendancy. This meant that the negotiations were likely to prove very contentious with the level of “brinkmanship” high.

Singer-Game-Theory-Post 2-Net-Influence-EMU-Game-Theater

Modes of Action

We refer to the methods by which players use their net influence as “modes of action.” The players in each “game theater” are trying to achieve their objectives, which involves proactively and reactively engaging in these actions. Among them, brinkmanship—deliberately creating risk that is out of one’s control—is the most critical mode of action players can take.

That’s because, according to economist and game theory authority Thomas Schelling, it creates an ex-ante deterrent rather than an ex-post punishment.

Brinkmanship—deliberately creating risk that is out of one’s control—is the most critical mode of action players can take.

“The brink,” he writes in The Strategy of Conflict, “is a curved slope that one can stand on with some risk of slipping … Neither the person standing there nor the onlookers can be quite sure just how great the risk is … It is the tactic of deliberately letting the situation get somewhat out of hand, just because its being out of hand may be intolerable to the other party and force his accommodation.”

Consider, as a modern example of brinkmanship, the citizens of Greece voting against a proposed bailout that included stringent austerity measures in the summer of 2015. This gave Alexis Tsipras, as leader of the governing Syriza party, the ammunition to remain strong in his stance against Greece’s creditors. This motivated both sides of the confrontation to raise the political stakes and move closer to the brink of a potential “Grexit” than they likely otherwise would have liked to.

These actions, while frightening and ostensibly irrational, advanced the negotiation toward resolution within the eurozone, ultimately culminating in a deal whereby Tsipras and his Syriza party capitulated on their opposition to the harsh terms of an official bailout.

What does this have to do with investing? Game theory provides a way for us to better organize and process the vast amount of information that affects global economies and markets. But I’ll discuss the application of game theory to investing more in a future post, and walk through an easy-to-understand game theater using our old friends Rocky & Bullwinkle.

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Copyright © 2019 William Blair & Company, L.L.C. "William Blair” is a registered trademark of William Blair & Company, L.L.C. No part of this material may be reproduced in any form, or referred to in any other publication, without express written consent.

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Please carefully consider the Funds’ investment objective, risks, charges, and expenses before investing. This and other information is contained in the Funds’ prospectus and summary prospectus, which you may obtain by calling +1 800 742 7272. Read the prospectus and summary prospectus carefully before investing. Investing includes the risk of loss.

Any statements or opinions expressed are those of the author as of the date of publication, are subject to change without notice as economic and markets conditions dictate, and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC or the Investment Management Division of William Blair & Company, L.L.C.

This content is for informational and educational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Investment advice and recommendations can be provided only after careful consideration of an investor’s objectives, guidelines, and restrictions.

Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Investments are subject to market risk. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

William Blair does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

Distributed by William Blair & Company, L.L.C., member FINRA/SIPC.

Copyright © 2019 William Blair & Company, L.L.C. "William Blair” is a registered trademark of William Blair & Company, L.L.C. No part of this material may be reproduced in any form, or referred to in any other publication, without express written consent.

Statement of Financial Condition | NMS Rule 605 & 606 | Business Continuity Plan | UK Stewardship Code
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