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Irene Bauer: Is game theory dictating asset allocation?

Irene Bauer: Is game theory dictating asset allocation?

It is quite clear that after the politics-led antics of 2016, the art of asset management has become an exercise in game theory. Second guessing what is going to happen next on the political front has never been easy, but now it seems it is more important than ever.

So what is the best way to do asset allocation? One of the main findings of the FCA’s asset management interim report in November was that more could be done on transparency of costs and the argument for passive funds seems to be winning the day.

Following the argument of Jack Bogle, the founder and retired CEO of Vanguard and long-time proponent of passives, one should just invest in the S&P 500 (or the FTSE 100 here in the UK). While this is the closest to a truly passive investment, I personally do not believe it is the most practical.

One still needs to make a range of decisions before deciding on one’s investments, namely about risk, exposures and the goal for the investment.

A person in their early years of working can take on a much higher risk in their pension than somebody already in the decumulation phase. In the latter case one might even be prepared to pay extra for a drawdown protection.

There is also the Ibbotson study that asset allocation drives around 90% of returns. In these tumultuous times, how does one determine when to change the asset allocation?

Active managers have seen their lunch eaten away by smart beta funds, which one might argue follow similar rules, only that the former has the manager’s discretion whereas the latter is purely systematic. Similarly, and using game theory, determine which asset and sub asset classes have performed best during certain scenarios, and apply this knowledge in a rules-based fashion.

For most countries, the signs are still bullish with the global economy currently in an expansion phase. But while central banks were controlling economies and markets since the global financial crisis, it seems the control has now shifted towards politicians.

Applying game theory to Europe, it will be about analysing the upcoming elections and their potential outcomes.

The probability of France or the Netherlands, or any other country exiting the European Union is not negligible.

What will it do to European policies if Marine Le Pen gets through the first round of elections and inches higher in the polls for the second round? Will it bring the eurozone closer together or to a breaking point? Similar with Trump, the equity market in the US seems to still have some legs with expectations of tax cut announcements and fiscal spending. The question is what will happen after that. Can he foster Reagan like growth, or will his fiscal stimulus increase inflation but disappoint on growth?

The more we are prepared for what the different outcomes in politics might do to markets the better. Let’s start with the game theory now while it is still game on for markets.

Irene Bauer is a founding partner at Twenty20 Investments

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