Is the Stock Market a Prisoner's Dilemma?

Question

Overview of Prisoners Dilemma: https://plato.stanford.edu/entries/prisoner-dilemma/

Picture of Prisoners Dilemma: https://www.flickr.com/photos/gforsythe/8245423564

Overview of the Efficient Market Hypothesis: https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

Picture of the EMH: https://image.slidesharecdn.com/12efficientmarkethypothesis-091013132117-phpapp02/95/efficient-market-hypothesis-7-728.jpg?cb=1255440102

Does an efficient market create a prisoners dilemma for investors? Is the stock market efficient, is the real estate market? What does that mean for our own investment decisions?

Short question: Someone with only the very best stock analysis will profit in a highly efficient market. Anyone doing even a little worse analysis will get no benefit. Doesn't this create a prisoners dilemma? Analysts compete for the highest quality analysis. Both expend increasing resources to out-compete each other, but only the winner makes a profit.

Long Question: Overview of the Efficient Market Hypothesis (EMH) --Feel free to skip if you know this already--

The efficient market hypothesis (EMH) is controversial. At once backed by the entire academic community, and at the same time with glaring real world exceptions. The efficient market hypothesis says that it's hard to pick winning and losing stocks, so the prices are almost always fair, and it's very difficult to beat the market. On the other hand market booms and busts are real, and investors like Warren Buffet and George Soros have historically beaten the market.

So what gives? Are the academics wrong? Here's my take.

The market is highly efficient, but not perfectly. Financial analysis can lead to profitable decisions. But once such analysis is done, all other analysts must do even higher quality analysis to gain any financial benefit.

I like to use a fruit tree as an analogy. And I like peaches so let's make it a peach tree. After a peach becomes ripe, it falls from the tree and anyone on the ground can pick it up and take it home. Some people decide to climb the peach tree and they are able to pick the fruits before they fall, so they get extra peaches. Others people seeing this decide they don't want to miss out, and try to climb the tree as well to get their share of the peaches.

Enter the prisoners dilemma. The best climbers will be able to climb the highest, and pick all the peaches before the others can get there. The other climbers, no matter how skilled, will get no peaches, but still expend all the effort to climb the tree. This is like the stock market where the best analysis makes a profit from picking the best stocks, and then competing analysts are left with nothing, while still expending tremendous resources on the analysis.

So the academics are right except at the very fringe. The best investment groups will be able to beat the market. But anyone less skilled can treat the market as efficient.

I realize this is a variant of the prisoners dilemma and not the original. Anyone have their own ideas? Or thoughts on how this connects to real estate. My impression is the RE market is highly inefficient and the same model does not apply. Maybe that implies the real estate market is the best investment for people willing to spend some time getting educated on their investments.

Kristina Sparrow · Answer

Yes, I'd argue that the stock market is a prisoner's dilemma. If we use your analyst research example, let's say the best analyst shares their research with everyone. The stock is more likely to move in the direction recommended by the analyst because of the increase in demand, creating more gains for everyone. True, followers would not see as much gain as the initial investor, but there is still a bigger gain to be shared for everyone. It's not like a peach tree because the peaches are a limited resource but stock market gains are not. This sharing of knowledge doesn't happen in reality because of HFT and the belief in EMH. I don't believe that the stock market is a perfectly efficient market, but it is definitely more efficient than real estate. I choose to invest in the most inefficient market available to me. Also real estate is the only market where it is encouraged and rewarded to trade on non-public information (ex: off-market deals..)

Shafi Noss · Answer

Hi Kristina, thanks for the response. It sounds like you're saying high quality analysis is not only an advantage to the analyst but to other buyers as well because when she buys an undervalued stock, the analyst increases demand and drives the price up until the stock is valued correctly. Because the price increases, anyone holding the stock benefits, analyst and followers included.

Although our examples are somewhat different, I hadn't thought about the potential gain shared by other investors in price correction of an undervalued stock. I've still got a few doubts though: for example the opposite would happen with an overvalued stock, driving total value down, and relying on price increases coming from investor psychology instead of intrinsic value runs the risk of creating bubbles via the greater fool theory. I'd be interested to talk with you more about this, feel free to send me a PM if you're interested in chatting.

Shafi Noss · Answer

I was reading about A Random Walk the other day, I'll check it out.

Ryan Seib · Answer

Have you read a Random Walk Down Wall Street? Great book. Also fascinating is the whole Chicago school of economics take on the EMH. I personally favor the Austrian approach.

Is the Stock Market a Prisoner's Dilemma?

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