In two previous posts, we discussed recent research from the respected Max Planck Institutes on how complex financial organizations make decisions in the face of uncertainty, focusing on so-called model uncertainty. In this third and final post on the topic, we shall focus on the second aspect of the research, strategic uncertainty- i.e., trying to address identifying who the other key players are in a market; what their actions may be; and how their decisions may affect outcomes.
Not surprisingly, the tenets of game theory feature in how decision-makers address this risk, but are sometimes honoured more in the breach rather than applied directly. One example is the apparent view of investment bankers that they can make other players predictable through direct action, rather than trying to guess their thinking and what an optimal outcome might be for all parties. Examples include testing pricing by placing orders, then swiftly cancelling them; or probing a client’s own strategy to see whether it conforms with previous experience or not. Perhaps this is an example of assuming that one always has superior knowledge or capabilities, an approach that can easily lead to ruin.
More usually, market participants try to develop a theory of the mind of others, relying upon intelligence-gathering and probing counterparts for potential weaknesses or vulnerabilities, and assessing their level of knowledge and sophistication. This seems more in line with game theory and an application of the poker-playing maxim that: “If you cannot find the sucker at the poker table, it’s probably you”. Clearly, understanding how others think is valuable, but it has to be tempered with avoiding becoming overly dependent upon an increasingly abstruse analysis of how others in turn think about you; how you might react to thinking about that; how the counterpart might think about you thinking about that…and so on. One can become trapped in the proverbial wilderness of mirrors by succumbing to such an approach, leading to terminal decision-paralysis. In reality, stopping at a relatively lower order of reasoning is likely to be much more functional and effective.
A third strand to coping with strategic uncertainty is considered to be communicating with others and thereby trying to influence them. In reality, none of us exists in isolation; and how and what we communicate is an essential part of achieving the most effective outcomes, even in the face of uncertainty. One question to bear in mind, however, as central banks recognize, is the extent to which one is merely providing information, or additionally trying to influence behaviour. We suspect that most financial market participants would aim for the latter.
And a final aspect to consider is whether one can actually change the rules of the game. One may be able literally to influence the behaviour and decisions of others; as well as reduce the level of uncertainty in a way favourable to the game-changer. Of course, such an attempt may be resisted for a variety of reasons; but it remains a valid, and acknowledged approach, although apparently not much studied.
In this, and the two previous posts on the topic, we have tried to give an overview of a complex and important area of research; where it seems to us there is more work to be done in order to understand better why financial market participants act and decide as they do. At Awbury, we believe that we need to absorb the knowledge generated by such studies in order to test and improve our own decision-making skills.
– The Awbury Team