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How game theory can help you trade the stock market

I was recently listening to an episode of Shane Parrish’s “The Knowledge Project” podcast featuring Adam Robinson. Adam Robinson is the co-founder of the Princeton Review and he also works as a global macro advisor to some of the world’s largest hedge funds. He’s been  a guest on Tim Ferriss’s podcast, which was how I initially discovered him.

One things I admire about Adam Robinson is that he approaches the world different than most. His contrarian viewpoints on the market have given me a different perspective of how to look at the market.

The traditional investment approaches

In his interview with Shane Parrish, Robinson breaks down the two most popular approaches to investing, and precisely why he doesn’t rely on them.

Fundamental analysis

The first approach is fundamental analysis. Fundamental analysis is the idea that you can analyze a business’s financial statements and competitors, while also taking into consideration macroeconomic conditions including interest rates, production, GDP, and so forth.

Fundamental analysts believe that they can accurately gauge that a company is accurately priced or not. These investors believe that they can determine the true value of a company based off a set of data about the company in about the economy. Adam Robinson states that the fundamental analysis view of investing is that you can figure something out about the world that nobody else has been able to figure out.

Technical analysis

The second popular investment approach is technical analysis. Technical analysis is the idea that you can forecast the direction of prices by understanding the past market prices and volume. Technical analysts believe that you can look at the price chart of an asset along with various technical indicators to understand where that asset’s price has been and where it’s going to go.

If you’ve ever heard about chart patterns such as head and shoulders, double top, double bottom, support, resistance, or indicators such as moving averages, fibonnaci retracements, RSI, MACD, this is how people view the market from a technical analysis perspective.

The biggest issue with technical analysis that Robinson notes is that you can easily trick yourself into thinking some event will take place in the market based off the chart pattern and indicators. The problem is that there’s still randomness that you have to deal with, and just looking at the price action of a security isn’t going to give you the entire picture.

A third approach: game theory

For this reasons, Robinson approaches the market using game theory. If you aren’t familiar, game theory is the process of modeling the strategic interaction between two or more players in some situation where there are specific rules and outcomes to the game.

Robinson’s uses game theory in the market, by waiting for different groups of investors to express their different views of the future. Once those investors express their views of the future (through buying and selling an asset), your job is to figure out which group is right.

You want to pay attention to differences of opinions amongst these groups of investors. You do this by focusing on those opinions which are strongly expressed, and try to figure out which investors are right. Robinson says “I can’t predict the future, but I can tell you what I need to see, to tell you the future is about to change.”

Getting into the minds of traders in the different capital markets

Robinson looks at capital markets from the perspective of those different groups of traders in the markets. In these groups you have stock traders, bond traders, currency traders, Metal traders, and energy traders. Each of these groups of investors express some view of the future through the investments that they make. All of these investors have strong incentives to make money, and take some action (buying or selling) that expresses those views.

Robinson goes on to say that a stock trader who is bullish on the economy (someone who thinks the economy will improve) is going to buy stocks. A bond trader who is bullish on the economy is going to buy corporate bonds and sell treasuries. A metal Trader who is bullish on the economy will buy industrial metals such as copper and iron and will sell precious metal such as gold silver and platinum.

Look for disagreements among different traders

With this perspective in mind, Robinson looks at where there is disagreement among investors. For example, if stock traders and bond traders differ in their views, Robinson states that 99% of the time the bond trader is right.

Sol if a stock trader is bullish on the market in a bond trader is bearish on the market, then you want to be bearish on the market.

Robinson says that of all of these investors, the metal traders are the most far-sighted and accurate group of traders. He says that metal traders have the most simplistic view of the world and they’re in touch with the world economy. The reason metal traders have to be far-sighted is because you have to plan for in advance when you’re extracting metals from the Earth.

Which traders are the most reliable?

With that being said, Robinson ranks the reliability of the various groups of participants in the markets as follows:

  1. Metal traders
  2. Bond traders
  3. Equity traders
  4. Oil traders
  5. Currency traders
  6. Economists
  7. Central bankers

Robinson pokes fun at economists and central bankers and say that they’re always wrong and are out of touch with what is actually going on in the economy. I would agree that the lack of skin in the game (credit Nassim Taleb) is what makes those two groups the least in touch with the market.

You have to anticipate the anticipation of other traders in the market. To quote Adam Robinson again “What I do, is look for these groups to express strongly, different views of the future. Then I express probabilistically, in the past, who tends to be right when these groups disagree.”

This has shifted the way I view markets

Hearing Adam Robinson talk about the market from the game theory perspective completely change the way that I approach the market. While I had been aware of the various markets out there, from commodities to bonds to currencies to stocks, I never knew how these different markets were related or how these different investors approached investing.

Looking at investing from a game theory perspective has opened up my mind and made me more aware of the different attitudes of the different traders in the market. I still have plenty to learn when it comes to these different markets, but this shift in thinking has been immensely helpful to me and I hope it will be a useful to you too.


Author: Trader Court

CPA first, pivoted to python programmer focused on data science which I apply to my own stock and options trading.

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