Recompound From a Game Theory Perspective
Recently I learned a little bit about game theory, specifically the prisoner’s dilemma. You can refer to the wikipedia page for a more detailed information as this article is only going to touch upon a couple of basic concepts. Then I will mention its relevance to Recompound as a service.
Prisoner’s Dilemma Intuition
The lesson we learn from prisoner’s dilemma is intuitive. It is mathematically describing that in a natural state, two rational actors with a one-off interaction can decide not to cooperate as their optimal strategy.
I will enumerate some natural scenarios to illustrate how intuitive this is:
A random stranger walks up to you and he is selling you his iPhone.
A salesperson from an unknown organisation that you don’t know offers you an obscure financial product.
You receive a text from an unknown person, offering you loans.
Would you entertain the offering or would you simply say no and walk away? For most, we will say no and walk away.
Now you could also think that most people we know do not have a job that walks up to people randomly without any credibility selling iPhones or financial products or loans. Usually these people work for Apple or a Bank that warrants them to do these things properly.
So if we establish the natural state, on a one-off setting (no representation of credibility and no track record) leads to no trust and cooperation between two actors in a single interaction. In other words, by default, the best strategy is not to trust. The next section describes this interaction in a more classic sense.
Prisoner’s Dilemma
If you already know about Prisoner’s Dilemma, feel free to skip this section.
Suppose you have two prisoners, Alice and Bob, who have been found to commit a crime. They are thrown into separate isolation cells with no means of communication. An investigator is trying to get more information about the crime from both of them. The way the investigation is conducted is as follows:
If Alice and Bob remain silent (cooperate), then each will be sentenced to 2 years of prison
If Alice divulges and Bob remains silent, then Alice will be set free and Bob will be sent to 10 years of prison
If Bob divulges and Alice remains silent, then Bob will be set free and Alice will be sent to 10 years of prison.
If both Alice and Bob divulge, then each will be sentenced to 5 years of prison
A rational actor would divulge information and betray because the best outcome for betraying is being set free and the worst outcome is 5 years of prison. If the actor stays silent, the best outcome for staying silent is 2 years of prison while the worst outcome is 10 years of prison. Since the best outcome for betraying is better than the best outcome of staying silent, the dominant strategy is to betray each other.
Therefore in a natural state, best strategy is to not cooperate.
When Assumptions Do Not Hold
More avid readers might question:
Why do we have trust and cooperation collectively as a society? Especially after you have mentioned that the natural state is to not cooperate.
By and large as members of the society, we do not trust random people. In comparison to the number of people in the society, the number of entity and people we trust is exceedingly small.
The following assumptions are true for people to not cooperate:
The game is one off
The actors cannot commit retribution when betrayed
If the assumption is different, we might realistically get a different outcome. In fact, if the game is repeated for an unknown number of times, it has been shown that actors in the game would choose to cooperate as a dominant strategy.
Why would people cooperate? Intuitively it is because the game comprised of multiple unknown rounds. Which means that if one actor decides to not cooperate, the other will refuse to cooperate with that actor in the next round. As a result, the payoff for the actor that betrays will be cut short.
In the Context of Recompound
In the natural state, it is easy to establish the fact that retails are largely unprofitable in the stock market. Go ahead and ask around your friends who have invested in the stock market. See their portfolio and then see if they are making money or not. Most likely the answer is no, especially during sideways or bearish times.
We are going to give an example of client X and Recompound sample game round. A game with Recompound has a duration of one month, Recompound’s objective is to make client X portfolio break its all time high value. So the breakdown of the outcome is as follows after one month and receiving an all time high:
Client X betrays Recompound and decide not to pay the fees. Client X gets 10, and Recompound gets -2
Client X cooperates with Recompound and pays the fees. Client X gets 8 and Recompound gets 2.
In this grossly simplified scenario, when it is a one-off game, it would be really easy to see that client X is better off betraying and not cooperating. Why bother paying Recompound? Client X gets to enjoy all of the proceeds from having an all time high portfolio.
However, the prerequisite of entering the next game is cooperation. If client X betrays Recompound, Recompound will not continue the service in the following month (reminder that there is a cost of keeping a client and helping them provide quality investment information). Client X knows that in the natural state, their portfolio is likely to be unprofitable. So they are better off cooperating with Recompound in the long run.
Having to always cooperate with Client X applies to Recompound as well. Consider the scenario where Recompound betrays Client X by dumping stocks when Client X is supposed to be buying. In this scenario Client X will no longer trust Recompound and will not move on the next game. In the long run, Recompound will no longer have clients. This goes against our intention of creating a sustainable business.
Therefore, as the number of games is unknown and the partnership is long term oriented, the interest of both parties involved in the partnership is to fulfill their responsibilities as best as they could.
Closing Remarks
In the context of Recompound, trust works both ways. Client trusts that Recompound would act in the best faith to consistently grow the client’s assets. Recompound trusts that client would act fairly at all stages of the partnership. Drawing lessons from iterated prisoner’s dilemma that are repeated ad infinitum, optimal strategy between two parties would be to trust and cooperate.