Like flipping a coin, rock-paper-scissors is an easy stand-in for a random decision (Thai or sushi tonight? 1, 2 ,3…), but you can improve your winning percentages by playing against a common cognitive biases.
Theoretically, the best way to play a game like rock-paper-scissors, which involves a string of random choices, is to be as random as possible so that your opponent can’t use patterns against you – reaching what’s called a Nash equilibrium (both players choosing at random). But people aren’t nearly as random as they try to be (or think they are).
Here’s what Charlie Munger had to say at the Daily Journal meeting
Charlie Munger spoke at the Daily Journal Corporation's Annual Meeting of Shareholders today. Although Warren Buffett is the more well-known Berkshire Hathaway chief, Munger has been at his side through much of his investing career. Q4 2020 hedge fund letters, conferences and more Charlie Munger's speech at the Daily Journal meeting was live-streamed on Yahoo Read More
Cognitive biases: The win-stay, lose-shift bias
Most employ what researchers from Zhejiang University in China call a ‘win-stay, lose-shift’ strategy. That doesn’t mean that someone will continue to throw scissors indefinitely, even if the opponent keeps throwing paper, but people are prejudiced towards what has just worked out for them and against what has just caused them to lose, even though it makes absolutely no sense in this context. The authors don’t claim to know exactly why this bias exists, but that doesn’t prevent other players from exploiting it.
Knowing that your opponent’s choices are weighted, you can increase your win percentage by playing around it: if you’ve just won you should switch it up, and if you’ve just lost you should switch to whatever beats your opponents last choice.
“This collective behavior contradicts with the NE theory but it is quantitatively explained by a microscopic model of win-lose-tie conditional response without any adjustable parameter,” says the study (h/t Jordan Chittley at KN Live). “Our theoretical calculations reveal that this new strategy may offer higher payoffs to individual players in comparison with the NE mixed strategy.”
In other words, people aren’t rational even when they are trying to be, so you shouldn’t play the game as if they are.
Cognitive biases in the market
None of this is surprising for contrarian investors. The ‘win-stay, lose-shift’ strategy sounds an awful lot like the investors who inevitably flood into a market at the end of a bull run and then sell into a bear market. The idea that people (even as a group) are good at advancing their own interests and at pricing new information into the market just doesn’t jive with experience. Every time we see another asset bubble crash, we have more evidence that people’s decision making is plagued by cognitive biases. If there’s a useful lesson from the rock-paper-scissors study, it’s that you should take those biases into account when playing the market.