19 Oct What Catherine Pichotta and Game Theory taught me about Investing
Avinash Dixit and Barry Nalebuff are professors of economics at Princeton and Yale respectively. They specialize in Game Theory. In 1991 they co-authored a best seller called Thinking Strategically and their second book The Art of Strategy: A Game Theorist Guide to Success in Business and Life is an extension of the previous.
Dixit and Nalebuff defines game theory as
Rigorous strategic thinking, the art of anticipating your opponents next moves, knowing full well that your rival is trying to do the same to you
The Prisoner’s Dilemma
The most famous instance of game theory is the prisoner’s dilemma where two prisoners are kept captive in isolation. The police does not have enough evidence to convict, and would require the cooperation of at least one prisoner. If both confess, they would end up with a standard sentence, say 2 years in prison. If both refuse to admit to the crime, they both get off with at most a fine.
At this stage it would seem sensible for both to deny vehemently their involvement. But if the police could get one to co-operate with them and confess, they would have sufficient evidence to find the non coorporative prisoner guilty and send him to jail for a long time. Hence, being the first to confess might be the safer option. The dilemma lies in both prisoners wanting to protect their own interest and in the process, actually compromising it.
The Prisoners’ Dilemma is but one example of game theory scenarios. There are many others. In fact, we are all game theorist in our everyday life. We play mahjong and try to double guess what our opponents’ tiles are. We go to meetings anticipating our bosses questions and objections. We sit for exams, and try to spot the questions that might show up and choose to concentrate our efforts on them. We buy an air ticket online because we think it is cheap and the price will not go lower. We are gaming against our mahjong kakis, our bosses, the examination board, the airlines and businesses.
Sometimes we are successful and come out ahead. Other times we are not so successful and end up being gamed instead.
The Art of Strategy
The Art of Strategy is laden with real life incidents. The authors uses examples from pop culture, art, sports, politics and business to illustrate how almost every human and business interaction has a game theory component to it.
The authors also shared many little nuggets of personal experience throughout their teaching and consulting careers, one of which is as follows.
Before the book was published, co author Barry Nalebuff distributed copies to his undergraduate game theory class in Yale and announced that for every mistake or typo the students identified, they would get a two dollar reward. The only catch being you would have to be the first to spot the error.
The intention was twofold. On one hand, his students would read the text cover to cover. On the other he could eliminate most mistakes before the book goes to press.
The person who ended up as the big winner was a lady called Catherine Pichotta. She did not find the most number of mistakes, there were others who were more prolific. Yet she walked away with the most money. How did that happen? Simply because unlike every other student, she thought ahead and decided to employ one killer strategy.
She started from the back of the book.
I was blown away when I read about it. It was elegant. It was easy. And it was such a simple solution right under the noses of everyone yet no one saw it. Catherine Pichotta not only won the game. She aced it totally.
Aceing the investment game.
As investors, we play the money game. We want to make the most money.
To ace the game, we would do very well to take a leaf out of Catherine’s book. Here is what I learnt from her.
Acting Against the crowd
Acting with the crowd is comfortable. It is fun to compete with everyone and see who can read faster and spot mistakes and typos others have missed. It is fun and safe to buy the same stocks that all your family and friends are buying. Or to purchase the investment property when all your neighbours are upgrading.
On the other hand, acting against the crowd is uncomfortable. Especially when it comes to investing, it requires tremendous courage and perseverance.
It is a well known adage that 90% of investors lose money. The crowd loses money. If you want to win the money game, do not do what everyone is doing. Act against the crowd.
Seeing through distractions
Many an eager Yale undergraduate in Barry Nalebuff’s class would have jumped into the book straight away. They wanted to be the first to spot errors. The faster you start the more errors you can spot before others get to it.
They were not wrong actually. It is a sound strategy. But is it the best strategy? Catherine saw through it all. She realized that speed is but a distraction. It is merely to throw people off the track. The emphasis on speed prevents people from stepping back and thinking clearly. They were blinded by the need to act, to do something.
And no other group of people in the world is as distracted by investors. We are bombarded by news, influenced by gurus and analysts gunning for our attention. We are ring fenced by analysts hawking their shares, fund managers peddling their funds.
We get jittery when we hear about stocks correcting in the US and feel compelled to act. A possible interest rate rise sends us scurrying. Potential mergers, buy overs, hot stocks, sexy stories.
Distractions. All of them distractions. They compel us to act, often in a manner detrimental to our investing fortunes. The sooner we learn how to see past it, the sooner we will be able to ace the game of money.
Understanding the game.
Finally, Catherine Pichotta understood the game. She saw that winning the game is not about finding the most typos. She goes beyond that. She went up a notch. She saw that winning the game is about finding the most typos that others have yet to find.
The ability to understand the game is crucial. If we as investors do not understand the game, we are simply going around in circles. And here I will define the big picture for you. The big picture is this – The big picture is not about making the most money.
Let me repeat myself again. The big picture is not about making the most money.
The big picture is about making the most money using the least possible effort exposing ourselves to the smallest amount of risk and making the money in the shortest possible time.
If you are only thinking about making the most amount of money, you are like the blind man grasping at the elephant’s tail and thinking that the elephant is long and thin. It is hardly a true representation of the elephant.
Put the other components into the game and you can see how the big picture changes. Would you employ a risky strategy that can potentially double (most money) or wipe out your capital or would you go for one that will give you 50 percent returns with a 20 percent downside?
Would you want to trawl through financial reports every evening and every weekend, forgoing precious family and leisure time for a 20 percent return (most money again) or would you go for a passive strategy that returns 15 percent?
Understand the game. There is no way an investor can win the game without understanding it. And as Catherine has shown, once you bring your understanding of the game up a notch, there is little chance of you losing it.
Game theory and Investing
I will leave you with what authors Dixit and Nalebuff had to say.
Though it involves simple common sense, much is counter intuitive and can only be mastered by a new way of seeing the world.
Of course the authors are talking about Game Theory, but deep in my mind I know without a doubt it is the greatest takeaway an investor can ever have.