In the current environment could applying a multi-player game theory framework be particularly helpful in analyzing the global capital markets…?

As Eric Beinhocker describes in his book, The Origin of Wealth, “There is no one best strategy; rather, the evolutionary process creates an eco-system of strategies – an ecosystem that changes over time through creative destruction.”  At 3EDGE Asset Management we believe in the inter-connectedness of the global markets viewed in terms of a non-linear, complex system.  Based on this belief, in addition to our other analytical tools including quantitative analysis, sound judgment and practical investment experience we have incorporated a multi-player game theory framework into our investment research process.

Typically, when analyzing the global capital markets, it is helpful to look back over history to find periods of time when similar conditions may have existed in order to attempt to understand what the future may hold.  However, in many respects the massive intervention by the world’s central banks since the onset of the financial crisis of 2008 has created an environment that has no clear historical precedent.   Never before have the world’s central banks been so enmeshed in the global economy and the markets.  As a result of this unprecedented and ongoing central bank activism, much of the world is experiencing an increase in the degree of currency manipulation, expanding government debt levels, and even negative interest rates in Japan and Europe.   At the same time, the U.S. Federal Reserve has inflated its balance sheet to over $4.5 trillion.  Since one cannot easily turn to history as a guide in the current environment, applying a multi-player game theory framework could be helpful because game theory is a method of analysis that is not reliant on past history.

Game theory is not new to the investment business and many people may know of the concept through the story of the Prisoner’s Dilemma, or Nash’s Equilibrium from the movie A Beautiful Mind.  In its simplest form, game theory is used to study situations in which there are a set of players, each with certain goals.  Then as the game begins each player must make a series of decisions in the hope of achieving his or her goal.  There is also a set of rules that map each player’s decisions to a set of future payoffs.  The players involved could be seen to be striving towards some measure of equilibrium.

Game theory is much simpler if there are a limited number of players and if the game or decisions present themselves a finite number of times.  Unfortunately, the global economy and capital markets present an environment where there are a multitude of players including the world’s central banks, governments, investors, consumers and producers.  Further, no one knows when the game may end and in some respects there is no clear end point.   Therefore, in order to successfully apply a multi-player game theory framework to analyzing the global capital markets, it becomes necessary to somewhat relax the aforementioned concept of equilibrium.  This adjustment away from seeking equilibrium is consistent with our belief that the global markets, particularly when analyzed at the asset class level, are rarely, if ever, in a state of equilibrium.   Quoting again from Beinhocker, “…the broad arc is leading us away from an equilibrium view of the economy (and the markets) toward an evolutionary, complexity-based perspective.”

Game theory has been applied to investing for some time now and that makes sense since the global markets represent an environment of constantly adapting strategies, actions and counter-actions among a variety of actors – all components of game theory.   However, perhaps more importantly, in the current environment (a result of eight years of unprecedented monetary intervention by the world’s central banks) where historical precedent is difficult to come by, game theory could play an even more important role since it is a method of analysis that is not reliant on past history.

Importantly, applying a multi-player game theory framework to something as complex as the global capital markets needs to be considered as supplemental, hopefully additive and only a part of an overall investment research process.

DeFred G Folts III
Chief Investment Strategist

DISCLAIMER: The observations noted above are provided exclusively to current and prospective clients of 3EDGE Asset Management, LP (“3EDGE”). They are not intended to provide personal investment advice and do not take into account the unique investment objectives and financial situation of the reader. Investors should only seek investment advice from their individual financial adviser. These observations include information from sources 3EDGE believes to be reliable, but the accuracy of such information cannot be guaranteed. Investments in securities, including common stocks, fixed income, commodities and ETFs, involve the risk of loss that investors should be prepared to bear. Past performance may not be indicative of future results.