Game Theory Inside Financial Planning

Content provided by our partner Bryan Kuderna, CFP®,LUTCF ~

If it snows for 6 days, must it stop on the 7th?  If a coin lands heads 9 times, must it land tails on the 10th?  If a kid drinks milk, must he grow tall?  If a man prays each night, must he find forgiveness?  If a market rises, must it crash?

Entropy is a frightening word… The degree of disorder or uncertainty within a system.  Is such chaos an acceptable property of life? What degree of disorder is palatable, or is there a corresponding price and reward for each level of acceptance?  Furthermore, can we ask history to repeat itself, and if so how? What is the cost of guaranteeing this planned future?

Entropy’s existence long ago birthed Game Theory, the study of mathematical models of conflict and cooperation between intelligent rational decision-makers.  The concept permeates nearly every decision of life, and therefore finds itself often at the center of the business world. It provides a scientific theorem for the timeless human desire for pattern recognition.  Unfortunately, if the title “Game” did not repudiate its validity initially, perhaps the gross assumptions within its definition will… mathematical models, conflict, cooperation, intelligent, and rational. Theorists have yet again given the homo sapiens’ prefrontal cortex far too much credit.

If we agree that all of life is to some extent an assumption, we must then look at which variables are worth assuming and the value each deserves.  Since its perhaps the greatest communicator of information available, let’s look at the stock market. The most notable figures in Target Pricing include projected Earnings Per Share (EPS), Price/Earnings (PE), Price/Book (PB), and Price/Sales (PS) ratios.  With up to the minute info available on the internet, any investor can achieve a relatively accurate valuation of a publicly traded company using such ratios, further assuming every company is operating with equal and valid accounting principles which could be a topic for another confusing paper.  Nevertheless, all these numbers are based on past information, forcing any valuator to try and predict the future. Enter “Head and Shoulders”, “Triple Bottom/Top”, “Double Bottom/Top”, “Saucers”, and a slew of other nonsensical, but widely utilized trends and patterns hoping to offer insight.

Anyone from a first-time investor up to the most reputed credit rating agency must then determine a relevant risk/reward ratio in consideration of the current risk-free rate.  After all, everything has a price. At least the roulette table clearly defines the potential downside/upside in every spin. The business world only offers one side of the equation, bankruptcy, whereas the upside is indeterminant (we won’t even touch shorting the market because two unknowns are then useless).  Therefore, we know every decision has a Lost Opportunity Cost, we just don’t know what that’s worth.

No one is allowed to turn a baffled eye since reward is the only way to financial independence, so then what about risk?  Unpredictability qualifies the importance of macro-financial planning over micro financial selection. Say if a plan were to have 100 unique variables we’ll identify as threats, is it possible to chip away one at a time to create a truly risk-free financial plan with any reward?  Is that completion not the selling point of one of finance’s oldest vehicles- Whole Life Insurance (i.e. guaranteed base returns, guaranteed outlays, no market correlations, tax deference and potential tax-free distributions, immediate death benefit, disability waiver of premiums, guaranteed insurability options, fluctuating dividends potentially addressing inflation, lending collateral, etc.).  But to jump ahead to creating foundational wealth before addressing protection and liquidity bears nearly the same risk of skipping to maximizing growth.

So, if we want to stick with Game Theory the investor must address one if its tenants, Zero-Sum Game, the situation in which one person’s gain must be equivalent to another’s loss creating a net-zero effect.  Excusing insider information and assuming perfect available information, only irrational investors offer the opportunity to pick the winning side. Otherwise, for every random winner, there will be another random and surprised, equal loser.  True believers of the Zero-Sum Game find universal growth the only path to a harmonic economy (i.e. ships go up and down with each swell, but all is ok if the tide is rising).

In conclusion, anyone who plans to deploy their income to further their wealth must seek to participate in such a hopeful rise, but not outpace it.  Furthermore, the investor must seek to participate as efficiently as possible (think fees, taxes, inflation, etc.) and with pure rationality (think unemotional, liquid, in control, etc.).  As was often said about His Airness, Michael Jordan, “You can’t stop him, you can only hope to contain him”, the investor must similarly view chaos, and play on the same team.

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