Asset Managers and the Prisoner’s Dilemma

Peer comparisons and misaligned incentives cause asset managers to follow the herd even to the detriment of asset owners, according to the Bank of England’s Thomas Belsham.

Why do asset managers sell when prices are falling? The answer might be found in a classic game theory example, suggests one Bank of England staffer.

In a new blog post, Thomas Belsham compared the incentives faced by asset managers to those faced by the convicts in Albert Tucker’s “Prisoner’s Dilemma.”

In the thought experiment, two prisoners face a two-year conviction for a crime, but are suspected of a more serious offense. Each is offered a deal: snitch on your partner and you can go free, but your partner gets seven years. If both snitch, each gets five years in jail.

Although keeping quiet seems like the obvious choice, game theorists argue that a rational thinker would snitch: No matter what the other person does, the snitch would face a better outcome (zero jail time instead of two years; five years instead of seven years). The Nash equilibrium, or game theory solution, is for both prisoners to snitch.

Asset managers face a similar “dilemma,” argued Belsham.

“In a period of financial stress, when there are concerns about falls in asset prices, rather than hold one’s nerve and stand pat, individual asset managers might reason that it is preferable to sell instead,” he wrote. “If all asset managers reason thus, the resulting rush for the exit—and downward pressure on asset prices—could result in considerably bigger losses for everyone, than if asset managers had coalesced on the cooperative outcome.”

For asset owners, there are two preferable outcomes: Either all asset managers hold on to their assets—or, if some managers have already sold, other managers should not follow suit. In both scenarios, potential losses are limited.

But asset managers don’t face the same incentives as asset owners, Belsham argued. For managers, performance in and of itself isn’t the most important consideration—what matters most is how they perform compared to their peers.

No matter what other managers do, it’s in an individual asset manager’s best interest to sell—if they sell and others don’t, the holders incur the losses; if everyone sells, everyone loses. Either way, the manager performs at least as well, if not better, than its peers.

“It becomes in an individual asset manager’s best interest to minimize deviation from the rest of the pack—because his or her reputation and ability to raise a new fund and operate henceforth are a function of relative performance,” he wrote.

So how can manager incentives be better aligned with those of the investor? Belsham suggested making selling more difficult or making peer comparisons less important—by emphasizing absolute return over benchmark performance, for example. Alternatively, we could all take a cue from game theorists.

“Cooperative outcomes also sometimes result from repeated games of the prisoner’s dilemma,” Belsham concluded. “Perhaps we should embrace opportunities for players to arrive at the cooperative outcome. A little volatility may not be a bad thing.”

Related: The Psychology of a Sell-Off