What does a 1950s thought experiment about two prisoners have to do with the next market crash?

In a recent episode of Investing Compass, Mark LaMonica and Shani Jayamanne explored one of the less obvious forces driving financial markets: game theory.

Investing isn’t a game where decisions are made in isolation. Investors are constantly responding to the decisions, expectations and incentives of other market participants.

That changes the way investors should think about everything from market bubbles to crashes.

In this episode, take a deep dive into what game theory can tell investors about market behaviour and how they can prepare for the next downturn.

You can find the full article here.

Other market insights:

The ageing ‘crisis’ has not and will not happen. Why it’s not going to play out like we think.

Australia’s $1 trillion debt pile. The real story behind the debt headlines.

Why Bitcoin surged to $80,000, and what may come next. US debt worries, inflows into ETFs, and a weaker dollar have triggered bitcoin’s latest rebound.

You can find the transcript below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Mark LaMonica: So, Shani, we are almost at our book anniversary, it’s been one year since our book came out. You were just talking about how you’re going to bring a copy of the book to your dentist. You have a dentist appointment after this, so something to look forward to.

Jayamanne: He calls me the Oracle of Morningstar.

LaMonica: The Oracle of Morningstar. Wow. Okay, I can speak to HR about changing your job title. So we’ll get on that. But to celebrate the one year book anniversary, we’re going to do a podcast episode where we answer questions from readers of the book. So if you have read the book, and it’s not too late if you haven’t, you can buy one and read it. If you have read the book, send the question to my email, [email protected]. That is in the show notes. Send the question, and we will answer those questions during that upcoming podcast episode. But let’s get into today’s podcast episode so Shani can go to the dentist. We’re going to talk about investor behavior. We know that’s always a popular topic. And we’re going to look at the behavior that goes into market crashes.

Market crashes, also a popular topic. So we think, and you wrote an article on this, and you use this analogy that many investors think that investing is a multiple choice test with only two answers. You’ve either got a good investment or a bad investment. And if you find the good investments, you get rewarded.

Jayamanne: And in reality, investing is more like a multiplayer game. The people you’re playing against matter in the outcome that you achieve. So we’re going to focus in on this a little bit and the behavior of the people that you’re playing against.

LaMonica: And we’re not saying that company earnings and other fundamentals don’t matter. They of course do, but it also matters how they compare to everyone else’s expectations. And that really matters in terms of the outcome that you will achieve. So a really good business can produce disappointing investment returns if it’s priced for perfection. On the other hand, a mediocre company can generate excellent returns if those expectations were excessively pessimistic.

Jayamanne: And I try to explain this to friends of mine who have received company shares as part of their remuneration package. They tell me that their company’s strong earnings and growth, but can’t figure out why the share price is stagnant.

LaMonica: And the reason for this is that investing isn’t a mathematical formula as much as we want it to be. Expectations and the decisions and opinions of other investors matter. Fundamentals, of course, matter, but so does studying how the decisions of others will influence your outcomes.

Jayamanne: So that’s what we’re going to focus in on today, and it’s called game theory.

LaMonica: And we’re going to lean into one of the best known examples in game theory to explain game theory to people that may not be familiar with it, and that is the prisoner’s dilemma. So it’s a famous thought experiment where two criminals are arrested. Both prisoners are placed into solitary confinement, so they have no means of communicating with each other. The police do not have enough evidence to convict either criminal on a severe charge, but they do have enough to convict both on a lesser charge. That lesser charge carries a sentence of one year. So the police, of course, offer both criminals the opportunity to testify against the other one. If they take the deal, they’ll be let off, and the other criminal will get three years, the more severe charge. If both take the deal, they will be sentenced to two years each. Neither criminal, of course, has any insight into what the other has decided.

Jayamanne: And so with this scenario, what we see is that both criminals do take the deal because they are worried that the other will inform on them. They each get two years, but the best action would have been to stay silent and both get one year. And investing has its own version of the prisoner’s dilemma.

LaMonica: And that’s what you wrote about in your article. And you use that, you included a chart from A&P in that article that looks at April 2025. And as a reminder, that was that whole tariff turmoil thing that happened last year. So if you do want to read the article, the link is in the episode notes. And you can take a look at this graph from A&P. And it shows investor sentiment, which includes surveys of investor newsletter writers and individual investors, and then looks at the ratio of puts, which are options to sell shares versus calls, which are options to buy shares.

Jayamanne: And what we see in the graph is the extreme pessimism that often leads to large dips in the index where investors clamor to remove themselves before others do. They don’t want to be the ones that are left holding the bag. And this is an example of the concept of loss aversion, where a loss feels twice as painful as an equivalent gain.

LaMonica: And then on the other side of that, of course, is when there’s extreme optimism, and that is when investors are trying to get into the market to capitalize on gains that they foresee before others do that. Now, imagine a world where more investors remain patient during a market correction. Share prices would likely recover much quicker, and everyone would benefit. But instead, what we actually see in real life is that many investors sell because they fear others are going to sell and they’re trying to get out of the market first. So those sales, of course, encourage further selling, which reinforces the original fear.

Jayamanne: And the same dynamic occurs during market bubbles. Investors buy not because they believe that the prices are justified, but because they believe someone else will pay even more for them tomorrow. And the important thing to remember here is that this behavior doesn’t rely on people being irrational. It just requires people responding to their perception of the incentives that they do face.

LaMonica: And so the best path as an investor is to avoid this collusion with the short-term prisoner dilemma thinking. So in other words, focus on those market fundamentals instead of just following the herd. Avoid portfolio decisions based on anticipating what everyone else is going to do. So that means making decisions based on frameworks that outline what does and doesn’t belong in your portfolio, irrespective of how you think others are going to react during the short term.

Jayamanne: So what game theory explains is why following the crowd isn’t always the safest option. When uncertainty increases, investors naturally look to others for reassurance. If everyone seems optimistic, buying feels safer. If everyone appears fearful, selling feels sensible.

LaMonica: And over the long term, markets have a habit of rewarding investors who can separate information from emotion. And that doesn’t mean that you’re always a contrarian, because oftentimes the crowd is actually right. What it means is recognizing that popularity itself isn’t evidence that an investment will pay off over the long term. By the time everyone agrees on an opportunity, much of that potential upside is probably already reflected in that share price.

Jayamanne: And every generation has had their version of this danger. So there was the dot com bubble, lithium, crypto, the list goes on. Some of these prove to be great long-term investments, but many investors still lose money because they buy at inflated prices.

LaMonica: And what we want you to take away from this episode is just thinking about incentives. So we know from game theory that incentives are important. Every participant in financial markets has different objectives, and sometimes we fall into the trap of thinking everybody’s trying to do the same thing.

Jayamanne: So a fund manager may be judged against a benchmark every quarter, so they’re expected to keep adjusting their portfolio while providing compelling justifications to clients. A CEO may face a short-term, may focus on short-term earnings because their remuneration depends on it.

LaMonica: And financial commentators, finfluencers are rewarded with attention by making bold predictions rather than actually admitting that there is a lot of uncertainty. Bold predictions generate engagement, and that’s what they’re trying to do. So ETF providers compete by launching products that attract investor attention, and really what they’re trying to do is encourage other investors to follow the herd.

Jayamanne: And none of these incentives are inherently bad. They’re simply different from the incentives that I face as I invest for the next 30 plus years for my retirement. I don’t need to outperform the benchmark every quarter, and I don’t need to have an opinion on every earning season.

LaMonica: And I think, you know, one thing, a trap that we fall into is sometimes we think, oh, fund managers and professionals aren’t smart. We look at some of those results we see against the benchmark and think these people don’t know what they’re doing, but no, they are intelligent people. They are simply responding to different incentives and incentives that may not be appropriate for individual investors. So just understanding this can help you avoid reacting to decisions that make perfect sense for someone else, but may not be appropriate for you.

Jayamanne: And I think one of the key insights from game theory is that being the best investor is less about intelligence and more about discipline. What we see is that success often comes from choosing the right game rather than trying to outsmart everyone else.

LaMonica: And we talk about this, and I’ve written on it, and I think there’s a link in the episode notes for this as well, and that’s edge. And if you are buying individual shares, you need to think about if you have an edge. And what an edge is, it’s just something that gives you an advantage over other investors, and that will allow you to be successful. So most investors can’t consistently predict earnings better than the market or forecast interest rates better than the market. The fortunate thing for us, of course, as a long-term investor is that we can pass off most of the work that we’re trying to do just simply to the passage of time. And this is not an edge that institutional investors have. So it’s a real opportunity for you and just think about incentives for other people, and a lot of those are short-term.

Jayamanne: Yeah, there’s absolutely no pressure for us to outperform this quarter or explain short-term underperformance to clients. We don’t have to listen or respond to daily market noise. Remaining invested in low-cost investments, diversifying appropriately for your goals and avoiding emotional decisions can be a powerful investment strategy.

LaMonica: And thinking about game theory, it’s really just a reminder that investing is just as much about human behavior as it is about finance. So every day, millions of investors are responding to uncertainty, to incentives, to headlines, and of course each other.

Jayamanne: And that interaction does create opportunities, but it also creates temptations to chase performance, panic during downturns, or assume that popular investments are automatically good ones. The investors who tend to succeed over long periods are necessarily the ones who know the most. They’re the ones that often understand the game that they’re playing.

LaMonica: Well, thank you very much for listening. I appreciate it. The Oracle of Morningstar appreciates it. And once again, if you have questions that you would like included in that book anniversary episode, please send that to my email address.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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