Why do asset managers sell when
prices are falling? The answer might be found in a classic game theory example,
suggests one Bank of England staffer.
In a new blog
post, Thomas Belsham compared the incentives faced by asset managers to
those faced by the convicts in Albert Tucker’s “Prisoner’s Dilemma.”
In the thought experiment, two
prisoners face a two-year conviction for a crime, but are suspected of a more
serious offense. Each is offered a deal: snitch on your partner and you can go
free, but your partner gets seven years. If both snitch, each gets five years
in jail.
Although keeping quiet seems
like the obvious choice, game theorists argue that a rational thinker would
snitch: No matter what the other person does, the snitch would face a better
outcome (zero jail time instead of two years; five years instead of seven
years). The Nash equilibrium, or game theory solution, is for both prisoners to
snitch.
Asset managers face a similar “dilemma,”
argued Belsham.
“In a period of financial
stress, when there are concerns about falls in asset prices, rather than hold
one’s nerve and stand pat, individual asset managers might reason that it is
preferable to sell instead,” he wrote. “If all asset managers reason thus, the
resulting rush for the exit—and downward pressure on asset prices—could result
in considerably bigger losses for everyone, than if asset managers had
coalesced on the cooperative outcome.”
For asset owners, there are two
preferable outcomes: Either all asset managers hold on to their assets—or, if
some managers have already sold, other managers should not follow suit. In both
scenarios, potential losses are limited.
But asset managers don’t face
the same incentives as asset owners, Belsham argued. For managers, performance
in and of itself isn’t the most important consideration—what matters most is
how they perform compared to their peers.
No matter what other managers
do, it’s in an individual asset manager’s best interest to sell—if they sell
and others don’t, the holders incur the losses; if everyone sells, everyone
loses. Either way, the manager performs at least as well, if not better, than
its peers.
“It becomes in an individual
asset manager’s best interest to minimize deviation from the rest of the
pack—because his or her reputation and ability to raise a new fund and operate
henceforth are a function of relative performance,” he wrote.
So how can manager incentives
be better aligned with those of the investor? Belsham suggested making selling
more difficult or making peer comparisons less important—by emphasizing
absolute return over benchmark performance, for example. Alternatively, we
could all take a cue from game theorists.
“Cooperative outcomes also
sometimes result from repeated games of the prisoner’s dilemma,” Belsham
concluded. “Perhaps we should embrace opportunities for players to arrive at
the cooperative outcome. A little volatility may not be a bad thing.”
Related: The
Psychology of a Sell-Off
