Unconventional investing approaches such as insider buying, corporate buybacks, and socially conscious initiatives will remain the investing antagonist to traditional growth and value investing approaches that have the potential to capture “alternative” returns.
This coronavirus pandemic and the societal ripple effects continue to metastasize. Over a year since its onset and during vaccination inoculations, it appears we may be emerging from this nightmare. However, recent developments such as Johnson & Johnson and AstraZeneca vaccine issues have added a wrinkle of doubt to the already slow progress pandemic. Regardless, though an unusual viewpoint to the situation, COVID-19 has matured into a social experiment rooted in behavioral reactions, self-interest, and cognitive and opportunity biases, exhibiting what game theorists coin a “prisoner’s dilemma.”
What is game theory, and how does it apply to markets?
Game theory is a branch of mathematics concerned with the analysis of strategies (investing, corporate, political, societal, etc.) for dealing with competitive situations where the outcome of a participant’s choice of action depends to some degree on the actions of other participants. In the 1944 book “The Theory of Games and Economic Behavior” by John von Neumann and Oskar Morgenstern, its origins are found. Game theorists attempt to test the decision nucleus of individuals (assuming all participants are rational) based on the game at hand. In our situation, “the game” is the coronavirus pandemic, and “this game” has a unique foundation: self-interest. Let me explain.
When infection levels are low in a particular area, people feel less at risk to follow preventative measures set forth by the CDC. Meanwhile, there is also a “wait and see” approach to receive vaccinations (potentially intensified with the Johnson and Johnson health concerns). Even though these skeptics reap the initial benefits from proportionately more of society being vaccinated, it does not eliminate the looming threat of not being vaccinated. These reactionary behaviors and skeptic perspectives create a situation best known as a prisoner’s dilemma. A prisoner’s dilemma explains that two entirely rational participants might not cooperate even if it appears that it is in their mutual best interest. Self-interest drives this relationship, thus not maximizing the utility of the situation. On one side, the strategy of minimizing regret reaches a point on the decision nexus known as the Nash equilibrium. However, though the bottom-line choice results from the noncooperative game theory, the Nash equilibrium is not the optimal choice in the game and will return to normalcy from the pandemic.
For investors, the area between the Nash equilibrium and the actual best decision to a situation (maximum utility output) is the arbitrage opportunity. Let us take a step back and think about a simple market example. The paradox of rationality explains that the irrational or unconventional approach often leads to the most desirable outcome. Those within the paradox are contrarians that do not fall victim to becoming bounded by over assuming outcomes, past experiences, and available information. As discussed in The Next Stage of Disruptors: Part 1, many times, making decisions off of available information can create legitimacy discounts that a contrarian may view as a great buying opportunity (against consensus opinion). The most recent example occurred in March 2020. If an individual invested $10,000 in the S&P 500 Index on March 23rd (market bottom), they would have approximately $18,900 through 04/14/2021. That is almost an 89% return. Ironically, many rational, sentiment-driven investors lost money throughout the pandemic (only recently recouping losses).
The main takeaway
Though this approach is the long way of saying investors and fund managers should think “outside of the box,” it is also saying that many alternatives, unconventional investment strategies have the edge on producing outsized relative returns. Alternative strategies and funds’ investing approach reside in the opportunity arbitrage created by the area between the COVID-19 game’s Nash equilibrium and utility maximization (best possible outcome). As discussed through Williamson’s transaction cost economics, individuals are inherently self-interested (rooted in opportunity biases) though some are more pronounced than others. It is fundamental human nature. In the same breath, cooperation is a long, complex relationship to mold due to its’ implicit, tacit agreement of “trust.” “Trust” is difficult to form but easy to lose. The combination of the ease to be self-interested and the difficulty to develop and maintain alliances (“trust”) create discounts throughout the market (which are the utility maximization that remains in a given situation). Many times, these discounts are indirect results from the macro game theory dynamics. In Deciphering a (COVID-19) Vaccine-Driven Economic Recovery: An Equity and Fixed Income Perspective, we discuss, in hindsight, the sectors in favor and not in favor throughout the pandemic uncertainty. Then in The “Great Rotation”: Is it Time for Value? we discussed the pendulum shift to value stocks as vaccine mobilizations cleared some of the uncertainty haze. Now amid increased vaccinations worldwide and some vaccine issues (Johnson and Johnson and AstraZeneca), we reside somewhere in between. As investors, it is crucial to understand these dynamics but approach the current investing environment through a piecemeal lens. As earnings roll in, many companies expect very strong earnings numbers this quarter as we start to emerge from COVID-19. However, are these earnings going to be sustained? As we gradually come out of the COVID-economy, fund managers and investors must understand the game theory dynamics of COVID-19 and the long-term trajectory of specific sectors in both stocks and bonds. Therefore, unconventional investing approaches such as insider buying, corporate buybacks, and socially conscious initiatives will remain the investing antagonist to traditional growth and value investing approaches that have the potential to capture “alternative” returns.