Monday, March 3, 2014

Thought Experiment

The mild turmoil in the markets today, spurred by events in Ukraine, has me thinking.

Let's suppose you want to make a play in the stock market based on a precarious military situation. You're either going to bet that the situation will get worse or that it will get better. (In reality, you're probably going to be hedging any such bet, but let's keep things simple.)

But let's imagine that this precarious situation isn't like the Russians in Ukraine. It's the Cuban Missile Crisis. In other words, the negative outcome isn't on the scale of disruption of European oil. It's global thermonuclear war.

We talk about how markets provide good evaluations of value and even decent predictors of outcomes. When there's money attached, people tend to -- as an aggregate -- make good calls.

But in this scenario, you're better off betting on a positive outcome disproportionate with that outcome's likelihood.

In the wake of nuclear war, all stocks would be worth precisely zero. This huge risk ought to make people respond by pulling out their investments. But other investments -- including gold and cash -- would be worth zero too. If humanity's even still kicking, the hottest commodities would suddenly be secluded underground bunkers and food with long expiration dates. And this is such a shock to the system that it's effectively unimaginable. There's no way to price it into the game.

It's like playing a board game in which, if someone rolls snake eyes twice in a row, you have to flip the board up into the air. It's hard to see how this possibility would affect in-game strategy.

(The analogy isn't perfect, because there's actually a way to hedge against nuclear war. Besides building shelters, you can invest in peace: industries that promote inter-dependence and politicians more interested in peace than looking strong or winning. That's actually a wise business move.)

But there's another reason not to properly price in the likelihood of events like nuclear war. If nuclear war happens, it's not just that your stocks go to zero. It's also that you are most likely dead.

In the cold logic of judging which is more likely, nuclear war might be a good bet. But humans rarely show anything resembling cold logic.

Would you rather make a landfall profit and live in a nuclear wasteland? Or would you rather make a good profit and still have beautiful paradises to retire in?

Put another way, we often treat the markets as if their goal is to identify value. That's often how markets work, because individual investors exploit opportunities, such as undervalued prices. But in fact, every individual investor wants to make money. And whether it's for himself or his clients, whether it's bound up in plans to provide for his family or prove himself or whatever, this is a personal motivation. And should things go south, in the wake of nuclear war, this hypothetical investor likely wouldn't be a person anymore. Whether you win or lose the game doesn't matter if you're dead. Because we're animals, and if making money is the game in this scenario, staying alive and thriving is the meta-game, which is really what we're all playing anyway.