This blog's content was taken from episode 301, "What's Considered Too Small of a Position in a Single Stock?"

You can go check out the whole episode here:

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Game theory is a theoretical framework for conceiving social interactions between rival participants. In some ways, game theory can be seen as the science of strategy, or at the very least as the best possible way for independent, rival agents to make decisions in a strategic context. 

By utilizing game theory, you are essentially attempting to make the greatest choice possible for yourself by taking into account what other actors will do as their actions will have an impact on your outcome and vice versa.

The classic illustration of this is the prisoner's dilemma. Two people are charged with the same offense, but they are not in contact with one another while speaking with prosecutors. Either party may choose to speak just when necessary, enter a plea of innocence, or confess their guilt while naming the opposing party.

Another example to understand this is how companies price their products. Apple with the iPhone is seen to be a great example of this. 

Background history:

The first iPhone came out in 2007 and it was a premium product. It wasn’t until 2013 that Apple came out with a less expensive version of the iPhone with the iPhone 5c. Even then, it wasn’t all that cheap with an MSRP of US$549 at the time. It wasn’t until 2016 that Apple launched a truly affordable version with the iPhone SE. 

 

By the time Apple came out with the cheaper version of the iPhone, there were already tons of low cost alternatives with android that had been available for years.

This is where game theory comes in. These are probably some of the considerations that Apple was looking at before they decided to come out with an affordable version of the iPhone.

  1. If we have a cheaper iPhone available in our lineup, will it impact the sales of our more premium, higher margin products?
  2. Will our iPhone revenues be higher or lower as a whole if we release a more affordable version.
  3. If we don’t have a cheaper version, will we lose customers to android rivals? Will rivals aggressively reduce their price to get customers?
  4. Will having a cheaper version impact Apple’s brand negatively in the eyes of their customers?
  5. Does having more customers in our ecosystem positively or negatively impact our other segments such as services?
  6. How will investors react if we have a cheaper phone?

Game theory can be used to try and understand how the action of certain actors will impact your investment. You’d be surprised how often you can use that to analyze different investment opportunities. 

You can also look at the meme stock phenomena and understand it better from a game theory perspective. 

Retail traders: 

  • Their actions as a collective will drive the price of the stock up. 
  • Once the price is up, each individual trader has a decision to make. 
  • Do you take profits now or keep going. If you take profits now, you lock those in but if you keep going, you hope that most of the traders do the same. If not, you risk seeing the value of the investment go down.

Shorts: 

  • Their decision is dependent on how leveraged they are and what they think retail traders will do. 
  • If they think retail traders will hold on, then selling sooner than later is probably the best outcome.