January 8, 2013
Complexity Leads To Irrational Decision Making In Games And Stock Markets Alike
redOrbit Staff & Wire Reports - Your Universe Online
When playing complicated games such as chess in which there are many different types of moves that are possible and required to win, researchers have found that a person's actions tend to become less rational — a discovery that could have profound implications for complex organizations like Wall Street.Simple games such as Tic-Tac-Toe (called ℠Noughts and Crosses´ in the UK) have only a handfull of possible, truly effective strategies for victory, according to Tobias Galla of the University of Manchester and Doyne Farmer of Oxford University. Conversely, more complex board and card games make it harder for players to develop optimal strategies, thus leading to less predictable, less rational behavior.
Galla and Farmer's findings came after the researchers simulated thousands of two-player games of varying difficulty levels in order to determine how human behavior in response to complex strategy-based situations can impact a person's decision-making process. They went on to note that their findings could apply not only to enjoyable pastimes like games, but to financial trading on stock markets as well.
Many economists base their financial predictions about the stock market on equilibrium theory, which assumes that economic players like traders and stock-brokers are infinitely intelligent and rational. Galla and Farmer contend that this is rarely, if ever, the case and probably leads to predictions about stock markets that are highly inaccurate.
Traditional game theory, which is used to generate models about strategic decision-making, is largely built around the idea of an equilibrium point. The assumption of an equilibrium point implies that ℠players´ possess a deep and perfect knowledge of what they are doing as well as what their adversaries are doing.
“Equilibrium is not always the right thing you should look for in a game. “¦ In many situations, people do not play equilibrium strategies, instead what they do can look like random or chaotic for a variety of reasons, so it is not always appropriate to base predictions on the equilibrium model,” explained Dr. Galla.
“With trading on the stock market, for example, you can have thousands of different stocks to choose from, and people do not always behave rationally in these situations or they do not have sufficient information to act rationally.”
Galla went on to explain how this behavior can have a “profound effect” on the way in which stock markets as a whole react in booms and busts. As a result, the team believes that it might be time to do away with traditional game theories for predicting people´s behavior and replace them with new models.
For their next project, Galla, Farmer and their colleagues are looking to expand upon their research to include games that involve more than just two players as well as games that change over time. They believe that these types of games would represent a closer approximation of how financial markets really function.
Preliminary results suggest that as the number of players increases, the chances that equilibrium will be reached decrease. Thus for extremely complex games with many players — like stock markets — the notion that players tend to move towards equilibrium becomes even less likely.
The study was published this week in the journal Proceedings of the National Academy of Sciences (PNAS).