Bubbles, COVID, The Stock Market, and Prisoner’s Dilemma
As the great philosopher Edward Christopher Sheeran, affectionally known as Ed Sheeran, once sang “Everybody’s talking ’bout exponential growth, And the stock market crashing in their portfolios. While I’ll be sitting here with a song that I wrote, Sing, love could change the world in a moment, But what do I know?” The wisdom of this song remains true from the beginning of time to this day – the stock market will rise, and it will crash, and people will talk about it. We’ve seen this happen in 1929, in 2000, and in 2008. Is it time for the bubble to burst again?
Why the stock market crashes depends on a variety of complicated and inter-connected factors, but to reduce it down to its simplest form, we can compare the market crash to a prisoner’s dilemma game. In a prisoner’s dilemma game, two prisoners are faced with two choices: to confess or to stay silent. If the two both stay silent, they both get no punishment; if they both confess, they both get prison time; if one confesses and the other doesn’t, the person who didn’t confess gets twice the prison time. As such, it is always better to confess. In the case of a stock market crash, we can think of investors as the prisoners in this game. Right as the market reaches its peak and the bubble is about to burst, there are two options: to sell one’s stock or to hold on to the stock. Assuming that the two players make up the entire market, if both players keep their stock, nothing happens. If one player decides to sell their stock and the other keeps the stock, the player who sold their stock gets the full profit and the person who keeps their stock makes no gains, and vice versa. If both sell, the market loses full value and both players lose money. Following this logic as well as the dominant strategy in a prisoner’s dilemma game, both players would sell, leading the bubble to burst and the market to crash. This shows how the prisoner’s dilemma game is illustrative of the typical behavior of investors right before a stock market crashes, as well as how investors selling leads to the stock market crashing.
In the current situation, there is general consensus that the tech sector, in which major players are the FAANG companies, is overvalued. However, COVID did not cause the market to crash, although it did take a dip in March when the crisis was at its peak. With the stock market recovering, we can assume that the value of tech companies will continue to rise. It will be interesting to continue monitoring the stock market and see whether the market will behave as it historically has, as well as whether it will behave as expected according to game theory.
References:
https://www.equitymaster.com/detail.asp?date=06/05/2008&story=4&title=Applying-Game-Theory-in-bubble-situation