The lacking Trust

(Blog n°3)

Because financial exchanges are based on relationship implying the presence of human beings, feelings, intuitions and values, the gravity of such exchanges may be pushed into the background. Indeed, today’s review will focus on the idea that, just like during the 1920s, finance is a game. Of course, any game can be fun, occupy the children during a rainy afternoon, but it is also and most importantly a way, a tool to understand the way the human mind works. Such a knowledge would help to understand the levers of a subject as finance, where psychological actions are the very core of the exchanges. However, before trying to understand the players mind, perhaps should the game be firstly analyzed.

Essentially, the core point of a game is to find an equilibrium, a state where nothing can change. Even if the financial game cannot end, it still can reach a balance. According to V. Pareto (1909), such an equilibrium can only be optimal. Indeed, the players being rational individuals, they can only adopt the most perfect situation. An optimum such as defined by V. Pareto is a situation in which the well-being of one individual cannot be improved without reducing the well-being of the other participants.

This kind of optimum can exist in the financial market (if the shareholder’s wealth is considered as their well-being). Indeed, the Pareto’s optima could be assimilated with the capital market line: an optimal situation in which the profitability of a portfolio cannot be improved without increasing the volatility of the portfolio. This capital market line is a market balance, fixed by the offer and demand law, by the “invisible hand”, so theoretically, it is a Pareto optimum (that follows Pareto’s assumptions).

However, players could be victim of bias. The economist and mathematician J. Nash theorized such a phenomenon in 1950. According to his theory, another equilibrium can be reached in a similar game that the one presented by Pareto. However, this other equilibrium is not an optimal one in the terms determined by Pareto. The most famous example of this kind of situation is the prisoner dilemma. A fictional situation where the lack of trust between two persons is key: because two prisoners accuse each other, they are both condemned to a sentence that could have been reduced if they would have remained quiet. Nevertheless, the game forced them to denounce each other by rewarding such an act. This reward created this lack of trust.

Trust. Again, it is the core point of the whole economic system. Trust in prices, in money, in computers are conditions for the global financial functioning. Therefore, the actors of the market are potential prisoners. A slight doubt can create a situation in which the well-being of the participants is not optimized, in which the objective of an optimal shareholder wealth is missed.

However, all of these theories assume that participants are purely rational. This point remains controversial.