Games. Online or good old fashion board games. Whatever your predilection, you might be forgiven for thinking they are simply an escape from reality.
But, could these interactive, imaginary worlds actually be training a generation of smart decision makers to improve their investment success?
We’re advocates of passive investing, a theory that has exploded in popularity recently. But many still wonder why it works so well. Believe it or not, the answer may lie in the art of strategic game play.
Have you ever heard of game theory? It is a branch of mathematics that studies how people behave when their outcomes depend on the decisions of others. It can be applied to a wide variety of situations in which the choices ‘players’ make interact to affect the overall outcome. For example, politics, business and economics.
The financial markets act like massive multiplayer games, with millions of opponents all attempting to outwit each other. Game theory helps to explain why trying to second-guess them often doesn’t work.
What is passive investing?
Passive investing does what it says on the tin. Instead of trying to ‘play’ the markets and pick individual winning stocks, you buy a broad range of investments and hold them long term. For example, when we build a portfolio for clients, it might comprise elements of the S&P 500, FTSE Global All Cap and/or MSCI World.
This diversification means if one area of investment underperforms, another may do well. Make no mistake, it is not an approach that is ever going to make you rich overnight, but the minimal trading involved means fees are low and there’s no need to try and stay ahead of the markets.
These features make passive investing one of the most reliable ways to build wealth over time. And why it aligns perfectly with game theory.
Rules of the game
Developed in the 1940s, game theory studies strategic decision making and is used to analyse situations in which the choices made by players are interdependent.
It shows that players consider each other’s possible decisions when formulating their own strategy, therefore, the result is determined by aspects that can be controlled, rather than pure chance.
Just like the outcome of online games, the way financial markets perform is influenced by its ‘players.’ Global politics and economic uncertainty are just some of the factors that determine whether stock prices rise or fall.
The millions who play the financial markets use information, analyse trends and attempt predictions before making their next move. Because of this, prices adjust quickly to new information.
Game theory tells us that in such a scenario, it becomes nearly impossible for any one player to consistently outperform the group. This is the foundation of passive investing.
The Nash Equilibrium strategy
In the early 1950s, an American mathematician, John Nash, invented the Nash Equilibrium, which is now considered one of the most important concepts within game theory.
Nash believed no one can predict the choices of multiple decision makers if they are analysed in isolation. Instead, you must determine what each player will do when taking into account what actions he or she expects others to take. The Nash equilibrium is achieved when no player can improve their outcome by altering their decision, assuming the other players’ decisions remain unchanged.
Active investing flies in the face of this theory. Traders are constantly fighting against each other and information is absorbed instantly. As a result, most fail to outperform the market after fees, taxes and trading costs have been deducted.
Conversely, passive investors step outside the competition and avoid the costs associated with active trading.
Cooperation not competition
Game theory shows that if everyone competes to outperform the market, the rational approach is not to compete at all. Buying a portfolio of diverse stocks is the Nash Equilibrium. That’s why long-term passive strategies can work better for most investors.
If everyone cooperated and invested passively, we would benefit collectively from low fees and long-term growth. However, because the stock market has millions of players, it is inevitable some believe they know best (active investment). They might win, but statistically, most won’t.
Unlike games where someone must lose, the stock markets grow as productivity increases, technology improves, companies innovate and global economies expand. This is the core reason why diversified funds build wealth across the decades.
Passive investing reduces risk, avoids competition, cuts costs and can capture long-term growth. So, if your adviser advocates this approach, it is not because they are lazy – they are simply wise enough to know you are unlikely to beat the game.
If you would like to know more about the benefits of passive investing, contact us for a free initial consultation on (01246) 298181 or email: enquiries@belmayne-ifa.com
