X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Applying 'Game Theory' in bubble situation - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Jun 5, 2008

    Applying 'Game Theory' in bubble situation

    What is Game Theory?
    Game is a competitive activity involving skill, chance, or endurance on the part of two or more persons who play according to a set of rules, usually for their own amusement or for that of spectators and Game theory is the science of strategy. It attempts to determine mathematically and logically the actions that "players" should take to secure the best outcomes for themselves in a wide array of "games". Game theory was pioneered by renowned mathematician - John von Neumann.

    The realm of game theory goes beyond the analysis of simple games. In real world, there are many competitive situations where game theory can be applied. Game theory can be applied to devise strategy in area of sales price wars, energy regulation, labor- management negotiations, bidding at auction, arbitration, advertising, agricultural crop selection, conflict resolution and also stock markets and insurance among others.

    Types of games
    The essence of a game is the interdependence of player strategies. There are two distinct types of strategic interdependence: sequential and simultaneous. In the former, the players move in sequence, each aware of the others' previous actions. In the latter, the players act at the same time, each ignorant of the others' actions.

    Sequential game can be analysed, by constructing a game tree map with all of the possibilities, then following the basic strategic rule: look ahead and reason back. Simultaneous game can be analysed considering all possible combinations. This can be most conveniently represented with a game table by listing the players and possible moves and outcomes.

    An example of strategic interaction
    Let us consider a simple and very famous example, called the Prisoner's Dilemma- two suspected felons (Lets say 'A' and 'B') are caught by the police, and interrogated in separate rooms. They are each told the following options:

    • If you both confess, you will each go to jail for 10 years.

    • If only one of you confesses, he gets only 1 year and the other gets 25 years.

    • If neither of you confesses, you each get 3 years in jail

    If suspect A keeps silent, then suspect B can get a better deal by confessing. If A confesses, B had better confess to avoid especially harsh treatment. Confession is B's dominant strategy. The same is true for A. Therefore, in equilibrium both confess. Both would fare better if they both stayed silent. Such cooperative behavior can be achieved in repeated plays of the game because the temporary gain from cheating (confession) can be outweighed by the long-run loss due to the breakdown of cooperation.

    There are several notable features in this game. First notable feature is that the both players have a dominant strategy. A dominant strategy has payoffs such that, regardless of the choices of other players, no other strategy would result in a higher payoff. This greatly simplifies decisions, if you have a dominant strategy, use it, because there is no way to do better. Second notable feature is that the both players also have dominated strategies, with payoffs no better than those of at least one other strategy, regardless of the choices of other players. This also simplifies decisions, dominated strategies should never be used, since there is at least one other strategy that will never be worse, and could be better (depending on the choices of other players). A final observation here is that if both prisoners use their optimal strategies (confess), they do not reach an optimal outcome. This is an important theme; maximizing individual welfare does not necessarily aggregate to optimal welfare for a group.

    Applying 'Prisoner's dilemma' in bubble situation
    Stock prices occasionally rise well above their fundamental values until at some point the "bubble" bursts and the price drops quickly. In this situation, if you are holding a stock, which is over priced, you can apply strategy used in prisoner's dilemma.

    Let us find out what are the options you have -

    • If you and other players sell stock then price will come down significantly

    • If only you sell and others doesn't sell then you will have limited profit

    • If neither of you sell then price would go further and can get you more returns

    In this situation, you should use dominant strategy i.e., sell your stock. It might be possible to fetch better returns by not selling stock but if your opponents use their dominant strategy then price will plummet and you will incur huge loss. Thus, in bubble market, the best strategy is to sell over priced stocks and take away whatever profits you have made before others start selling and the bubble bursts.

     

     

    Equitymaster requests your view! Post a comment on "Applying 'Game Theory' in bubble situation". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Will They Haul Off Trump's Statue, Too? (Vivek Kaul's Diary)

    Aug 16, 2017

    All across the country, the old gods become devils. New, gluten-free gods take their places...

    This Company Beat the Business World's 'Three Killer Cs' (The 5 Minute Wrapup)

    Aug 16, 2017

    And what it has in common with beating the stock market too.

    5 Steps To Become Financially Independent (Outside View)

    Aug 16, 2017

    Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

    Let's Hope This Correction Continues (The 5 Minute Wrapup)

    Aug 14, 2017

    Last week's correction is making a number of Super Investor stocks look a lot more attractive...

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    Proxy Plays: A Smart Way to Bet on 'Off Limits' Companies(The 5 Minute Wrapup)

    Aug 4, 2017

    The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 16, 2017 (Close)

    MARKET STATS