Most of the time we fail to apply concepts learned in a real world, The prisoner’s dilemma, a paradox in decision analysis is one such example. If we can apply the learning’s from this case, it can do wonders to our investment philosophy and journey. Let’s understand the case and its application in investing.

Understanding the Prisoner’s Dilemma

The classic prisoner’s dilemma goes like this: two members of a gang of bank robbers, Karan and Arjun, have been arrested and are being interrogated in separate rooms. The authorities have no other witnesses, and can only prove the case against them if they can convince at least one of the robbers to betray his accomplice and testify to the crime. Each bank robber is faced with the choice to cooperate with his accomplice and remain silent or to defect from the gang and testify for the prosecution.

  1. If they both co-operate and remain silent, then the authorities will only be able to convict them on a lesser charge of loitering, which will mean one year in jail each (1 year for Karan + 1 year for Arjun = 2 years total jail time).
  2. If one testifies and the other does not, then the one who testifies will go free and the other will get three years (0 years for the one who defects + 3 for the one convicted = 3 years total)
  3. if both testify against the other, each will get two years in jail for being partly responsible for the robbery (2 years for Karan + 2 years for Arjun = 4 years total jail time).

The paradox of the prisoner’s dilemma is this: both robbers can minimize the total jail time that the two of them will do only if they both co-operate (2 years total), but the incentives that they each face separately will always drive them each to defect and end up doing the maximum total jail time between the two of them (4 years total).

Learning’s from Prisoner’s Dilemma

  1. From Karan’s point of view, if Arjun remains silent, then karan can either co-operate with Arjun and do a year in jail, or defect and go free. Obviously he would be better off betraying Arjun. On the other hand, if Arjun defects and testifies against Karan, then Karan’s choice becomes either to remain silent and do three years or to talk and do two years in jail. Again, obviously, he would prefer to do the two years over three. Similarly as an investor, if we do not know which direction markets are heading to, we will always be better of investing in funds which have a higher upside capture ratio is market is gaining or vice versa situation lower downside capture ratio if market is losing. Therefore the funds with higher upside to downside ratio will yield in better returns.
  2. If Karan knows Arjun and knows That Arjun is going to remain silent, then Karan can defect and go free. Similarly as an investor, if we (fairly) know which direction markets are heading to, we will always be better of investing large sums in equities if market is gaining or vice versa situation investing in debt or gold if market is losing.

What should we do as an investor?

Most experts in market often get only 55-60% of their predictions on the markets right. So it will be foolish to assume that we are an expert and can predict market moves correctly. In that case, we should always do three things:

  1. Stick to the Strategic Asset Allocation (Whats your strategic asset allocation?)
  2. Invest in the funds, stocks with lower chances of losses (How to do that?)
  3. Re-balance once a year to the least but not more than 2-3 times

Once you gain some experience in the markets over the years and your market predictions are on average more accurate then you can graduate to change the step one to Dynamic asset allocation but not the other 2. Even in dynamic asset allocation you never get out of an asset class 100% or invest only in 1 asset class 100%. for e.g.

Ravi has a strategic asset allocation based on his risk appetite, capacity and time horizon basis of 70% equity, 25% Debt and 5% Gold. So when he graduates to Dynamic Asset allocation still his ranges should be Equity 50-70%, Debt 25-40% and Gold 5-10%. Not outside of these ranges.

Hope you will apply the same and make the most of your investments. Happy Investing!

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