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Game theory in the popular press.

In match penny stock theory, playing to win is a losing bet

The Business Journal (Milwaukee)
Pete Kendall
November 21, 1997
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Peter Bernstein's book, "Against the Gods," tells the story of John von Neumann, a Hungarian physicist who contributed to the discovery of quantum mechanics. Von Neumann also introduced the world to game theory with a 1926 paper that proved the only rational way to win at a childhood game called match penny was to try not to win.

In match penny, two players turn up a coin at the same moment. If both coins are heads or tails, then player A wins. If different sides come up, player B wins. With a complex set of equations, von Neumann revealed that the trick to playing match penny is to "avoid losing."

"Certain defeat results from any strategy whose aim is to win," Bernstein writes. "So you should play heads and tails in random fashion, simulating a machine that would systematically reveal each side of the coin with a probability of 50 percent. The only rational decision for both players is to show heads and tails in random fashion."

Bernstein may not have intended it, but this is the key point of his book. As the cover jacket explains, "Against the Gods" is "a richly woven tale of Greek philosophers and Arab mathematicians, of merchants and scientists, gamblers and philosophers, world-renowned intellects and obscure but inspired amateurs who helped discover the modern methods of putting the future at the service of the present, replacing helplessness before the fates with choice and decision."

For 1,000 years, Bernstein's heroes labored to fashion out of numbers a commercial order in which all risks were neatly organized. Modern man's 1990s commitment to risk and reward in the global stock market is one of this effort's crowning achievements. As the book jacket also notes, "When investors buy stocks, risk is their inescapable partner."

But in the investment realm, the moral of stories like Bernstein's applies only so long as the stories go untold -- or at least unheard. Now that Bernstein's book has climbed the business bestsellers list and met with widespread critical acclaim, the markets have undoubtedly moved on to the next lesson.

Redefining risk

The new lesson is necessarily the opposite of the old, which takes me back to von Neumann's match penny game. After seven years of indiscriminate mutual fund buying, the public is making the fatal match penny error of playing to win.

This newfound and ultimately destructive impulse is reflected in the rhetoric of market advisers, who have redefined risk as the chance you take when you fail to bet on a sure thing.

Because stocks always rise in the long run, the only uncertainty that stands between the average person and wealth is the gumption to get in. Or as public television's pied piper of stock investment, Louis Rukeyser, has said: "The greatest risk most people take in investing is not taking enough of what they initially perceive to be risk."

Rukeyser isn't alone in his assessment. Jean-Marie Eveillard, a money manager with SoGen International, is part of a chorus of analysts echoing the very same sentiment in the weeks leading up to the Oct. 27 decline of 554 Dow Jones Industrial Average points.

"If equity markets continue to be so strong, I worry that caution will no longer be a virtue, but a vice," Eveillard said in the November issue of Smart Money magazine.

Not so nifty

If Bernstein's history is accurate, the new emphasis on the risk of not being in the market is almost unprecedented. In "Against the Gods," I found just one reference to a point in the past when risk was similarly redefined.

In the early 1970s, Bernstein notes, "portfolio managers became so enamored with the idea of growth in general, and the so-called Nifty Fifty growth stocks in particular, that they were willing to pay any price at all for the privilege of owning shares in companies like Xerox, Coca-Cola, IBM and Polaroid. These investment managers defined the risk in the Nifty Fifty, not as the risk of overpaying, but as the risk of not owning them."

In January 1973, the Nifty Fifty slipped into the biggest stock market decline since the Great Depression.

I tried to reach Bernstein at his New York City office to ask if there were any other periods in which risk was reclassified in this manner, but he declined to come to the phone. Barbara Bernstein, the author's wife, however, assured me that she was familiar with the subject matter and said that the only other instance that she could think of was 1929.

I checked back and found that, as enamored as people were with the stock market in 1929, no one went so far as to suggest it was a gamble to stay out of the market. At least, I could not find any quotations to that effect.

But there was this from the E.H. Simmons, president of the New York Stock Exchange: "I cannot help but raise a dissenting voice to statements that we are simply living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the future."

This remark is significant, not just because it shows the stock market can look like a fool's paradise and still be one, but also because it comes from the president of an institutional that traditionally exercises extreme discretion when it comes to forecasting the direction of the market.

Upside down rhetoric

In the late 1920s, the president of the New York Stock Exchange slipped, just as Richard Grasso, the current head of the exchange, has in recent months. But Grasso has gone further in adopting the rhetoric of the New Era bulls who masquerade as risk managers.

"This is a time, some say, of unparalleled risk if you're in equities," Grasso said in a September address to the National Association Investment Clubs. "I would say there's great risk in being out of them."

This statement stands common sense on its head. If it is true when the Dow was at 8000, then it is doubly true now that it's off its highs by more than 500 points. That nasty deflationary snowball rolling in from Asia must be the opportunity of a lifetime. And in a world where risk is your best friend, Saddam Hussein is Santa Claus.

If things suddenly seem upside down, it's probably because a psychological process known as a bear market has begun. Bear markets progress from denial to surrender. Most investors aren't even in denial yet.

This time they have the added burden of a twisted faith in their ability to eliminate the chance of loss with exposure to loss.

1997 American City Business Journals Inc.