The stock market continues to navigate a precarious tightrope this week, carefully balancing its steps while avoiding looking down.
Congress has even managed to reopen the government—at least until January 30. This break allows members to enjoy their holidays before they return to Washington, where they will likely resume their pretense of productivity after the new year.
For discerning investors facing inflated valuations and increasing uncertainty, finding solid ground can be challenging. What strategies can knowledgeable investors deploy to identify even a hint of certainty amidst such volatility?
To explore this query, we can draw insights from one of the most brilliant minds of the 20th century: John von Neumann. This Renaissance figure influenced disciplines from quantum mechanics to digital computing and played a role in the development of the first American atomic and hydrogen weapons.
Born in Budapest in 1903 and educated in Berlin at a top scientific institution—one that once deemed Einstein unworthy of a research grant—von Neumann is often celebrated as the “founder of game theory.” He was also notable for his ability to multiply eight-digit numbers in his head.
Beyond his groundbreaking mathematical theories and algorithms, von Neumann possessed a pragmatic approach to problem-solving—an invaluable mindset for navigating today’s complex market.
A classic anecdote encapsulates his philosophy. When asked to describe certainty, he provided a remarkably practical example. He stated that to ensure certainty, you must first design a house with a living room floor that can withstand heavy stress. To do this, you should:
“Calculate the weight of the grand piano with six men huddled over it to sing. Then triple that weight.”
This principle offers assurance.
From Piano Floors to Probability
Reflect on the simplicity of this statement. For von Neumann, certainty didn’t entail the absence of risk; rather, it involved significantly overcompensating for potential risks.
It was about constructing a floor strong enough not just for the expected load but for an improbable party scenario multiplied by a factor of three.
This concept can be applied to your investment strategy by implementing a comprehensive stress test where you build in a substantial safety margin. In today’s inflated market, this idea warrants serious consideration.
The story of the piano is a simple illustration, yet it reflects von Neumann’s significant contributions to probability and game theory.
In 1944, von Neumann co-authored Theory of Games and Economic Behavior with economist Oskar Morgenstern, establishing game theory as a distinct discipline. At its core, game theory explores strategy and decision-making, particularly when outcomes hinge upon the choices of others.
Von Neumann examined how rational players can achieve the optimal outcome (later termed the Nash Equilibrium) under conditions of incomplete information and competitive actions.
Herein lies a connection to the piano analogy: In any complex scenario—whether a duel, poker game, or economic environment—you can’t merely anticipate the most likely outcome. Instead, you must assess the worst reasonable scenario and design your strategy to endure it.
Our “Maximum Load” Scenario
This strategic mindset has two crucial implications for investors:
First, just because the market is expected to rise indefinitely does not necessitate that you should fully commit to that single outcome. Game theory compels you to consider competing variables: unexpected inflation, geopolitical upheavals, widespread panic sell-offs.
Second, consider the Minimax Strategy. A foundational element of von Neumann’s zero-sum game theory, the Minimax theorem posits that a rational player aims to minimize the maximum potential loss, rather than seeking the highest possible return.
The grand piano tale is a specific application of the Minimax principle in structural engineering: focus on minimizing the risk of a floor collapse.
Currently, we find ourselves in a market characterized by extreme overvaluation. Indicators such as the Shiller P/E Ratio, Price-to-Sales, and market capitalization relative to GDP reveal that stock prices are well above historical norms. The foundational “load” of the stock market—i.e., the anticipated future earnings justifying current valuations—is already considerable.
If the expected load is substantial, what would the tripled load look like? What worst-case scenarios should we be prepared for?
We are not simply staring down a minor correction; we are facing a confluence of systemic stresses.
This includes a prolonged recession causing a long-term downturn in corporate earnings, persistent high inflation pushing interest rates up, and the dramatic devaluation of high-flying growth stocks that have been priced for perfection.
Imagine if all three of these adverse scenarios were to unfold simultaneously.
How to Use Game Theory to Protect Your Wealth
Investors applying von Neumann’s principles should not focus solely on identifying a stock poised to double in value. Instead, the aim is to build a resilient portfolio that can endure market downturns.
Practically, this involves selecting companies with robust cash reserves. Are they financially equipped to weather not just one year of poor performance but potentially three?
If the economy stalls, can they maintain operations and fulfill their debt obligations? If interest rates were to rise sharply, would the company still manage to meet its financial commitments effortlessly?
This strategy also necessitates a brutally realistic approach to assessing a company’s fair value. What if a company’s earnings growth slows to 5 percent per year instead of the expected 15 percent?
Furthermore, extreme diversification is essential. This extends beyond acquiring stocks from various sectors to include a mix of asset classes—cash, commodities, gold, and even some real estate investments.
Certainty, as defined by von Neumann, is a deliberate action rather than a passive state. It involves actively choosing to overbuild, over-save, and overprepare against the worst possible outcomes.
Investing is undoubtedly a competitive arena, and von Neumann’s work serves as a rulebook for navigating through it successfully.
So, if you find yourself enticed by the latest high-flying stock, buoyed by the flimsy narrative of an AI revolution promising limitless growth, remember the grand piano. Assess the maximum stress that economic realities could impose on a company’s earnings, valuation, and industry, then multiply that stress by three.
If your stock or portfolio can endure this rigorous test and is priced attractively enough to prosper post-collapse, then you may have achieved the type of certainty that John von Neumann would endorse.
An overly pessimistic approach? Perhaps. However, given today’s inflated valuations and economic uncertainties, actively preparing for the worst possible economic outcomes is essential.
[Editor’s note: Join the Economic Prism mailing list to receive a complimentary copy of an important report titled “Utility Payment Wealth – Profit from Henry Ford’s Dream City Business Model.” If you’re interested in a special trial offer for MN Gordon’s Wealth Prism Letter, you can obtain that here.]
Sincerely,
MN Gordon
for Economic Prism
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