Implicit assumptions and game theory in personal finance

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plsgoobs
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Implicit assumptions and game theory in personal finance

Post by plsgoobs »

During my morning walk I was thinking about personal finance theory and implicit assumptions for the basics. We all know the basics of personal finance, a la "save 20% of your income", retire at 25x expenses, etc. What struck me is that, especially with regards to retirement, there are some implicit assumptions that are not well articulated.

For example, does the 25x expense rule hold more true if someone owns a home versus rents? If so in this case, the 25x expenses rule has an implicit assumption that the retiree owns a home.

What really got me thinking is the application of game theory to personal finance for younger people. While we typically encourage saving 20% as a good rule of thumb, is thinking of personal finance as a single player a fallacy? Given the competitiveness of the housing market, rising wages and expenses, etc, it seems that personal finance should also take into account "the competition." Is this captured in standard personal finance theory?

BL: What are some implicit assumptions of basic personal finance? And is basic personal finance considered a single player game when it really shouldn't be?
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Re: Implicit assumptions and game theory in personal finance

Post by nicktenny »

I see personal finance as a clear single player game with a few very straightforward variables: income and expense. It only becomes a multi-player game if you let other motivations take precedent (image, worrying about what others think, keeping up with the Joneses). Now, while that part is simple, living life and deciding how to use your money is not always simple.

As for your thoughts about whether home ownership affects the 25x study, I see no assumption. Your expenses include everything. So if you rent, it includes your rent payments. If you own, it includes your property taxes and maintenance. Still just simple math as long as you have proper estimates of your expenses.
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Re: Implicit assumptions and game theory in personal finance

Post by CyclingDuo »

plsgoobs wrote: Sun Jun 09, 2024 10:04 am During my morning walk I was thinking about personal finance theory and implicit assumptions for the basics. We all know the basics of personal finance, a la "save 20% of your income", retire at 25x expenses, etc. What struck me is that, especially with regards to retirement, there are some implicit assumptions that are not well articulated.

For example, does the 25x expense rule hold more true if someone owns a home versus rents? If so in this case, the 25x expenses rule has an implicit assumption that the retiree owns a home.
A home is an expense. So the calculated expenses include what continued home ownership costs. If one is renting, then the expense of renting is included in your calculations.
"Save like a pessimist, invest like an optimist." - Morgan Housel | "Pick a bushel, save a peck!" - Grandpa
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Re: Implicit assumptions and game theory in personal finance

Post by Sandtrap »

A tacit assumption or implicit assumption is an assumption that underlies a logical argument, course of action, decision, or judgment that is not explicitly voiced nor necessarily understood by the decision maker or judge.
Implicit psychology and social cognition posits that the majority (most) of our motivations, actions, reactions and responses, et al, is largely unknown to ourselves. And, at our core, for most, incognizant.

Thus, to come up with definitive quantitative actionable and substantive "rules of thumb" (25x is not) et al, is moot, given the premise of the question.
And, it is very common, albeit tempting, to follow the path from a verifiable fact and data, to assumptions and conclusions that are presumed factual.

This is why the standard very detailed "portfolio review format" is used for personal financial review and also to comment on financial questions in best context. There are no assumptions in the numbers provided.

However, there are far wiser folk here well versed and experts in these fields, so . . . (insert standard dis laimer).
j :D
Last edited by Sandtrap on Sun Jun 09, 2024 10:29 am, edited 3 times in total.
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alex_686
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Re: Implicit assumptions and game theory in personal finance

Post by alex_686 »

plsgoobs wrote: Sun Jun 09, 2024 10:04 am For example, does the 25x expense rule hold more true if someone owns a home versus rents? If so in this case, the 25x expenses rule has an implicit assumption that the retiree owns a home.
The 25x rule isn’t a rule. It is a historic observation being used as a heuristic guideline.

As such, there are no underlying assumptions. Any pressure put on the 25x rule will cause the entire thing to fall down like a house of cards.

Not saying there isn’t wisdom, but recognize what you have here.

Also, no game theory. Game Theory is how 2 actors negotiate. There isn’t a second person in the room here.
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Re: Implicit assumptions and game theory in personal finance

Post by Thesaints »

“Save 20% of your income”
“You will need 80% of your salary in retirement”
The assumption is evident
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Re: Implicit assumptions and game theory in personal finance

Post by CletusCaddy »

One area where game theory would apply and cut against standard Boglehead advice is for tech workers compensated heavily in company stock who live in tech heavy areas.

Standard advice is to diversify that stock as soon as they vest.

However when all of your coworkers are holding those RSUs and they skyrocket, you are shut out from buying a home. Better to do what everyone else does, you are all in the same boat that way.

The same rationale applies to holding more domestic stocks than market cap. You are exposed to your home currency and that justifies home bias.
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Re: Implicit assumptions and game theory in personal finance

Post by Thesaints »

CletusCaddy wrote: Sun Jun 09, 2024 10:26 am Standard advice is to diversify that stock as soon as they vest.

However when all of your coworkers are holding those RSUs and they skyrocket, you are shut out from buying a home. Better to do what everyone else does, you are all in the same boat that way.
???
The benefit of moving away from a single stock into an index is 10 times larger when the single stock is in the company one works for.
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Re: Implicit assumptions and game theory in personal finance

Post by plsgoobs »

nicktenny wrote: Sun Jun 09, 2024 10:17 am I see personal finance as a clear single player game with a few very straightforward variables: income and expense. It only becomes a multi-player game if you let other motivations take precedent (image, worrying about what others think, keeping up with the Joneses). Now, while that part is simple, living life and deciding how to use your money is not always simple.
I like this framework, thank you!
nicktenny wrote: Sun Jun 09, 2024 10:17 am As for your thoughts about whether home ownership affects the 25x study, I see no assumption. Your expenses include everything. So if you rent, it includes your rent payments. If you own, it includes your property taxes and maintenance. Still just simple math as long as you have proper estimates of your expenses.
I guess I make an assumption that expense stability of owning a home is much different than renting, in the vein of personal inflation rate, which is inherently captured by the "expenses" part of the study. Which then leads my pondering of how does the variability of expenses impact the foundational personal finance recommendations. Does that make sense?
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Re: Implicit assumptions and game theory in personal finance

Post by plsgoobs »

alex_686 wrote: Sun Jun 09, 2024 10:25 am
plsgoobs wrote: Sun Jun 09, 2024 10:04 am For example, does the 25x expense rule hold more true if someone owns a home versus rents? If so in this case, the 25x expenses rule has an implicit assumption that the retiree owns a home.
The 25x rule isn’t a rule. It is a historic observation being used as a heuristic guideline.

As such, there are no underlying assumptions. Any pressure put on the 25x rule will cause the entire thing to fall down like a house of cards.

Not saying there isn’t wisdom, but recognize what you have here.
Thank you. I recognize the value of using heuristics especially for the basics. I keep things as simple as possible for helping my family navigate personal finance, but as I dive deeper into personal finance, I like to think about more of the complexities.
alex_686 wrote: Sun Jun 09, 2024 10:25 am Also, no game theory. Game Theory is how 2 actors negotiate. There isn’t a second person in the room here.
Game theory can apply to more than just two players. n-player games are much more complex though. In my line of thinking here, I don't see how personal finance is not an n-player game as your decisions impact, and are impacted, by others' decisions outside of your control.
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Re: Implicit assumptions and game theory in personal finance

Post by plsgoobs »

Thesaints wrote: Sun Jun 09, 2024 10:46 am
CletusCaddy wrote: Sun Jun 09, 2024 10:26 am Standard advice is to diversify that stock as soon as they vest.

However when all of your coworkers are holding those RSUs and they skyrocket, you are shut out from buying a home. Better to do what everyone else does, you are all in the same boat that way.
???
The benefit of moving away from a single stock into an index is 10 times larger when the single stock is in the company one works for.
Can we consider game theory as a mathematical approach to implementing portfolio optimization based off an individual's risk tolerance? Sure, the equilibrium might say the best for all actors is VTSAX, but holding a single company's stock can still pay off more than the rest of the field for some.
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Re: Implicit assumptions and game theory in personal finance

Post by Thesaints »

plsgoobs wrote: Sun Jun 09, 2024 11:01 am Can we consider game theory as a mathematical approach to implementing portfolio optimization based off an individual's risk tolerance? Sure, the equilibrium might say the best for all actors is VTSAX, but holding a single company's stock can still pay off more than the rest of the field for some.
Yes, but there is no reason to make such a bet on the company you work for. That’s unrewarded risk and it is a big risk.
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Re: Implicit assumptions and game theory in personal finance

Post by plsgoobs »

Sandtrap wrote: Sun Jun 09, 2024 10:25 am
A tacit assumption or implicit assumption is an assumption that underlies a logical argument, course of action, decision, or judgment that is not explicitly voiced nor necessarily understood by the decision maker or judge.
Implicit psychology and social cognition posits that the majority (most) of our motivations, actions, reactions and responses, et al, is largely unknown to ourselves. And, at our core, for most, incognizant.

Thus, to come up with definitive quantitative actionable and substantive "rules of thumb" (25x is not) et al, is moot, given the premise of the question.
And, it is very common, albeit tempting, to follow the path from a verifiable fact and data, to assumptions and conclusions that are presumed factual.

This is why the standard very detailed "portfolio review format" is used for personal financial review and also to comment on financial questions in best context. There are no assumptions in the numbers provided.

However, there are far wiser folk here well versed and experts in these fields, so . . . (insert standard dis laimer).
j :D
Thank you for the wise words. What prompted this thought was that I realized I didn't truly understand all the underlying assumptions of several of the common personal finance recommendations, while fully recognizing that personal finance is hard and the best way to teach people is to not immediately overwhelm them so they can just start. Because saving sub-optimally is far better than not saving at all.
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Re: Implicit assumptions and game theory in personal finance

Post by CletusCaddy »

Thesaints wrote: Sun Jun 09, 2024 10:46 am
CletusCaddy wrote: Sun Jun 09, 2024 10:26 am Standard advice is to diversify that stock as soon as they vest.

However when all of your coworkers are holding those RSUs and they skyrocket, you are shut out from buying a home. Better to do what everyone else does, you are all in the same boat that way.
???
The benefit of moving away from a single stock into an index is 10 times larger when the single stock is in the company one works for.
You need to define "benefit" in this situation.
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Re: Implicit assumptions and game theory in personal finance

Post by alex_686 »

plsgoobs wrote: Sun Jun 09, 2024 10:56 am Game theory can apply to more than just two players. n-player games are much more complex though. In my line of thinking here, I don't see how personal finance is not an n-player game as your decisions impact, and are impacted, by others' decisions outside of your control.
Because, effectively, n is infinite. Your actions will have no meaningful impact on assets price levels. There are so many other players that you wouldn’t even move the needle if you went out and bought a $100m of anything particular. Well, maybe for a day or 2. Maybe for a small cap. You are a drop of water in a pool.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: Implicit assumptions and game theory in personal finance

Post by Thesaints »

CletusCaddy wrote: Sun Jun 09, 2024 11:11 am You need to define "benefit" in this situation.
“Not losing your capital AND your job at the same time”
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Re: Implicit assumptions and game theory in personal finance

Post by KlangFool »

plsgoobs wrote: Sun Jun 09, 2024 10:50 am
I guess I make an assumption that expense stability of owning a home is much different than renting, in the vein of personal inflation rate, which is inherently captured by the "expenses" part of the study. Which then leads my pondering of how does the variability of expenses impact the foundational personal finance recommendations. Does that make sense?
plsgoobs ,

That is wrong!

Personal finance is personal.

"It depends"

If someone is not normal, how does any study about normal people is relevant? For example, if someone only buy house when owning is significantly cheaper than renting, how does a study about housing expense of normal people relevant.

"Which then leads my pondering of how does the variability of expenses impact the foundational personal finance recommendations"

Why should a person's annual expense be dependent on how others choose to spend their money? It may not be. For some people, they decided that they only going to spend nominal 60K per year. So, they will do whatever necessary to keep the annual expense at 60k per year. How is the official inflation rate matters?

Normal people buy X'mas present before X'mas. Abnormal person buys X'mas present after X'mas when it is on sale. Ditto, abnormal people buy Halloween costume after Halloween and use it for the next Halloween.

At the personal/individual level, a person has total control on how and when they choose to spend their money. And, the more that they are different from normal people, the less competition that they have.

My take on personal finance is do not be normal.

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Re: Implicit assumptions and game theory in personal finance

Post by plsgoobs »

alex_686 wrote: Sun Jun 09, 2024 11:12 am
plsgoobs wrote: Sun Jun 09, 2024 10:56 am Game theory can apply to more than just two players. n-player games are much more complex though. In my line of thinking here, I don't see how personal finance is not an n-player game as your decisions impact, and are impacted, by others' decisions outside of your control.
Because, effectively, n is infinite. Your actions will have no meaningful impact on assets price levels. There are so many other players that you wouldn’t even move the needle if you went out and bought a $100m of anything particular. Well, maybe for a day or 2. Maybe for a small cap. You are a drop of water in a pool.
Ah, right. I know there are ways to model population games but it's been a while since I've studied game theory. Thanks for the input!
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Re: Implicit assumptions and game theory in personal finance

Post by alex_686 »

plsgoobs wrote: Sun Jun 09, 2024 11:01 am Can we consider game theory as a mathematical approach to implementing portfolio optimization based off an individual's risk tolerance? Sure, the equilibrium might say the best for all actors is VTSAX, but holding a single company's stock can still pay off more than the rest of the field for some.
This is kind of my day job.

Never used game theory. Too many actors, each with too little power. The actions of the Federal Reserve might be a edge case but the impact tends to be narrow.

Probability theory with a emphasis on stochastic processes is the mathematical leg. Investment accounting, a subset of normal accounting is another.

The basic standard method is to estimate expected market returns, volatility, and co-variance of your asset classes. Then optimize to meet your goals. Then realize that you have a ton of model error. Then use wisdom to adjust.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: Implicit assumptions and game theory in personal finance

Post by CletusCaddy »

Thesaints wrote: Sun Jun 09, 2024 11:12 am
CletusCaddy wrote: Sun Jun 09, 2024 11:11 am You need to define "benefit" in this situation.
“Not losing your capital AND your job at the same time”
So we define it differently.

I define it as “being able to afford the scarce necessities that you are competing with your neighbors for”

Which is where the game theory comes in.

There is a Nobel Prize waiting for the economist who can integrate the insights of game theory with modern portfolio theory.
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Re: Implicit assumptions and game theory in personal finance

Post by Thesaints »

CletusCaddy wrote: Sun Jun 09, 2024 11:30 am
Thesaints wrote: Sun Jun 09, 2024 11:12 am
CletusCaddy wrote: Sun Jun 09, 2024 11:11 am You need to define "benefit" in this situation.
“Not losing your capital AND your job at the same time”
So we define it differently.

I define it as “being able to afford the scarce necessities that you are competing with your neighbors for”

Which is where the game theory comes in.

There is a Nobel Prize waiting for the economist who can integrate the insights of game theory with modern portfolio theory.
Since you cannot buy anything by paying in RSU’s, I’m not sure I see your point.
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Re: Implicit assumptions and game theory in personal finance

Post by retired@50 »

plsgoobs wrote: Sun Jun 09, 2024 10:04 am BL: What are some implicit assumptions of basic personal finance? And is basic personal finance considered a single player game when it really shouldn't be?
As to the implicit assumptions, the most obvious one to me is that the stock market will appreciate over your time horizon. While this has historically been true for many time periods, it's still an "assumption" that most investors are making. Some bears may be making the opposite assumption.

The number of players becomes relevant when one is trading frequently. Someone, on the other side of the trade, holds the opposite view of that stock you're selling, so the question becomes "who is correct?".

Regards,
"All of us would be better investors if we just made fewer decisions." - Daniel Kahneman
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Re: Implicit assumptions and game theory in personal finance

Post by upwind »

plsgoobs wrote: Sun Jun 09, 2024 10:04 am During my morning walk I was thinking about personal finance theory and implicit assumptions for the basics. We all know the basics of personal finance, a la "save 20% of your income", retire at 25x expenses, etc. What struck me is that, especially with regards to retirement, there are some implicit assumptions that are not well articulated.

For example, does the 25x expense rule hold more true if someone owns a home versus rents? If so in this case, the 25x expenses rule has an implicit assumption that the retiree owns a home.

What really got me thinking is the application of game theory to personal finance for younger people. While we typically encourage saving 20% as a good rule of thumb, is thinking of personal finance as a single player a fallacy? Given the competitiveness of the housing market, rising wages and expenses, etc, it seems that personal finance should also take into account "the competition." Is this captured in standard personal finance theory?

BL: What are some implicit assumptions of basic personal finance? And is basic personal finance considered a single player game when it really shouldn't be?
Own or rent both have expense. The question is how might these change over time. The desire to move could change expenses significantly as could lifestyle changes. This is particularly true for people who currently live very cheaply.

I have selected a retirement expense number much higher than my current expenses. At least 1.8 times after rounding the base up. This still leaves me well short of that other rule of thumb concerning 80% of last annual income so doubling expenses and targeting x25 expense doesn’t seem unreasonable as target for me. I currently have very low expenses and feel they could grow through need or desire significantly. Every situation is unique and rules of thumb are just that. It’s a reasonable approximation that at best may work out for most most of the time.

My assumption is all assumptions are suspect. We are making decisions under uncertainty. Play the probability but have contingencies. A set of strategies or options vs a plan. Now that maybe a plan but when most people think plan they really lay out an itinerary almost. It’s relatively fixed and there are too many assumptions about how things will unfold. We don’t have that sort of foresight.
“Investing is the intersection of economics and psychology.” - Seth Klarman
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Re: Implicit assumptions and game theory in personal finance

Post by upwind »

plsgoobs wrote: Sun Jun 09, 2024 10:04 am Also, no game theory. Game Theory is how 2 actors negotiate. There isn’t a second person in the room here.
I think the OP to some degree was making the point we are impacted by the decision of others or more to the point that the decisions of others need to be considered when we make decisions as this may effect our outcomes.

At its heart game theory is really about “probability and decision making under uncertainty”. I think that was even the title of one of our books in class on game theory. OK the consequences of outcome is critical part too. The classic two player examples are just that; classic examples from early game theory and just scratch the surface.
Last edited by upwind on Sun Jun 09, 2024 1:02 pm, edited 1 time in total.
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Re: Implicit assumptions and game theory in personal finance

Post by upwind »

KlangFool wrote: Sun Jun 09, 2024 11:17 am.

At the personal/individual level, a person has total control on how and when they choose to spend their money. And, the more that they are different from normal people, the less competition that they have.

My take on personal finance is do not be normal.

KlangFool
Ultimately we all operate within a social organization. Some of us live in mansions and some under the overpass. However, none of us operate in a vacuum.

As an example, we almost all are betting on the US equities market to some degree. This is dependent on things bigger than us. It may be a mistake. Things that have never happened before happen all the time.

Incidentally I wonder if bring “normal” in our mass production society isn’t the low “competition” low cost route. Being unique is costly both financially and in some cases socially which can in turn be financial. But now I’m in the weeds.
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Re: Implicit assumptions and game theory in personal finance

Post by stan1 »

Game theory assumes rational actors. Assuming rational actors is probably not a good assumption for personal finance even on this forum where we see a lot of emotion in posts on many topics.

Personal finance has a lot of future focus, so probability and psychology are probably better suited than mathematics and statistics most of the time. Also depends on whether we are talking about personal finance of one household (yours or mine) vs a personal finance of a demographic group like Boomers or Gen Z.
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Re: Implicit assumptions and game theory in personal finance

Post by unwitting_gulag »

plsgoobs wrote: Sun Jun 09, 2024 10:04 am... it seems that personal finance should also take into account "the competition." Is this captured in standard personal finance theory?

BL: What are some implicit assumptions of basic personal finance? And is basic personal finance considered a single player game when it really shouldn't be?
Much depends on whether we regard savings/investment/retirement as a narrowly personal journey of meeting one's expenses (with some margin of safety)... or whether we view pursuit-of-wealth as a competition, to rise in the pecking order. If the former, then we still "compete" with others, in the sense of inflation being the result of many people have the money to buy stuff, and therefore, we need more money ourselves. But if we're not comparing ourselves with others, if we don't care who has Vanguard Flagship Select vs. mere Flagship, then the competitive-aspect and hence the game-theoretic aspect is more subtle. If others "win", do I also win? Does my "winning" require their loss? Is it all zero-sum? Or, maybe everyone who invests, wins, while the non-investors lose? Hard to say.

Looking under the hood, the BH mindset may be considered in game-theoretic terms. What determines stock prices? This and that... but ultimately we don't know. The "winning strategy", so to speak, is something to do with index-funds, with buy-and-hold and so on. These principles, on which most of us agree, can be derived from a game-theoretic concept, or at least look more solid, if we posit that at least they're consistent with game theory.
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Re: Implicit assumptions and game theory in personal finance

Post by beachtech »

CletusCaddy wrote: Sun Jun 09, 2024 10:26 am One area where game theory would apply and cut against standard Boglehead advice is for tech workers compensated heavily in company stock who live in tech heavy areas.

Standard advice is to diversify that stock as soon as they vest.

However when all of your coworkers are holding those RSUs and they skyrocket, you are shut out from buying a home. Better to do what everyone else does, you are all in the same boat that way.
By extension, should people who live near BIG_CORP (and hope to buy a house there) but don’t work there take their taxable portfolios and go long on BIG_CORP stock?
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Re: Implicit assumptions and game theory in personal finance

Post by CletusCaddy »

beachtech wrote: Sun Jun 09, 2024 3:12 pm
CletusCaddy wrote: Sun Jun 09, 2024 10:26 am One area where game theory would apply and cut against standard Boglehead advice is for tech workers compensated heavily in company stock who live in tech heavy areas.

Standard advice is to diversify that stock as soon as they vest.

However when all of your coworkers are holding those RSUs and they skyrocket, you are shut out from buying a home. Better to do what everyone else does, you are all in the same boat that way.
By extension, should people who live near BIG_CORP (and hope to buy a house there) but don’t work there take their taxable portfolios and go long on BIG_CORP stock?
That is the implication yes
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Re: Implicit assumptions and game theory in personal finance

Post by Florida Orange »

Game theory assumes that the objective is to win the game. In investing, winning means making as much money as possible with your investments. But it's not just a math problem. Money has an emotional component to it. Maybe making as much money as possible isn't the only, or even the best, definition of winning.
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Re: Implicit assumptions and game theory in personal finance

Post by retireIn2020 »

plsgoobs wrote: Sun Jun 09, 2024 10:04 am During my morning walk I was thinking about personal finance theory and implicit assumptions for the basics. We all know the basics of personal finance, a la "save 20% of your income", retire at 25x expenses, etc. What struck me is that, especially with regards to retirement, there are some implicit assumptions that are not well articulated.

For example, does the 25x expense rule hold more true if someone owns a home versus rents? If so in this case, the 25x expenses rule has an implicit assumption that the retiree owns a home.

What really got me thinking is the application of game theory to personal finance for younger people. While we typically encourage saving 20% as a good rule of thumb, is thinking of personal finance as a single player a fallacy? Given the competitiveness of the housing market, rising wages and expenses, etc, it seems that personal finance should also take into account "the competition." Is this captured in standard personal finance theory?

BL: What are some implicit assumptions of basic personal finance? And is basic personal finance considered a single player game when it really shouldn't be?
Definitely single player. First you learn all of the rules and learn how to play. Then you take advantage of the rules as you become experienced.

Once you become an advanced player, you know how to manipulate the rules!
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Re: Implicit assumptions and game theory in personal finance

Post by crefwatch »

Don't confuse Game Theory and Social Psychology. There are a vast number of pitfalls based on mental and perceptual fallacies, for example.
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Re: Implicit assumptions and game theory in personal finance

Post by upwind »

crefwatch wrote: Mon Jun 10, 2024 7:01 am Don't confuse Game Theory and Social Psychology. There are a vast number of pitfalls based on mental and perceptual fallacies, for example.
Although I’d prefer focus in general on the second than first it’s a strange admonishment given that Social Psychologists study and do research in game theory and you can take courses in game theory for credit as a Social Psychology course through Psychology and Sociology departments. It’s not just the domain of Economics.
“Investing is the intersection of economics and psychology.” - Seth Klarman
upwind
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Re: Implicit assumptions and game theory in personal finance

Post by upwind »

alex_686 wrote: Sun Jun 09, 2024 11:12 am
plsgoobs wrote: Sun Jun 09, 2024 10:56 am Game theory can apply to more than just two players. n-player games are much more complex though. In my line of thinking here, I don't see how personal finance is not an n-player game as your decisions impact, and are impacted, by others' decisions outside of your control.
Because, effectively, n is infinite. Your actions will have no meaningful impact on assets price levels. There are so many other players that you wouldn’t even move the needle if you went out and bought a $100m of anything particular. Well, maybe for a day or 2. Maybe for a small cap. You are a drop of water in a pool.
Roaring Kitty

That impacted a number of long and short positions. Creating winners and losers.

Also it doesn’t have to be about the actions of one in isolation. The actions of many move things so what people do individually does matter and considering that can benefit the individual decision maker. For an active momentum investor trading is nothing but a game of chicken except the most favorable outcome is no one swerves.
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Re: Implicit assumptions and game theory in personal finance

Post by alex_686 »

upwind wrote: Mon Jun 10, 2024 9:06 am Roaring Kitty

That impacted a number of long and short positions. Creating winners and losers.
Yes, the exception that proves the rule. Note, GameStop is a small company with low liquidity and a high shorted position - only this made it possible. On the flip side, I can point to dozens of similar cases during the dot.com boom and bust when I was working on the margin desk. I saw lots of people short no-revenue dot.com stocks, saw the stocks go up 10x, wipe out the short sellers, and then go bankrupt. The market can remain irrational longer than you can remain liquid.

Game theory just doesn't apply to a Boglehead portfolio.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: Implicit assumptions and game theory in personal finance

Post by upwind »

alex_686 wrote: Mon Jun 10, 2024 9:25 am
Game theory just doesn't apply to a Boglehead portfolio.
In an actionable sense probably not. Hard to see how it could.
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hand
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Re: Implicit assumptions and game theory in personal finance

Post by hand »

To me, biggest implicit (and often incorrect) assumption is that the goal for individuals is to maximize wealth. This is often coupled with an inexact concept of risk tolerance - how scary a roller coaster ride can one tolerate.

Maximizing wealth is easy to model, and is how many market participants operate, however is not or should not be the goal of many individuals.

Many individuals would be better served to first prevent excessively negative outcomes:


1) Assets don't drop below a minimal viable threshold for housing, food and care security + an individually determined quality of living threshold

2) Wealth generation or market fluctuations do not negatively impact health (e.g., stress) or family / community relations

Only after these priorities have been met, does it make sense to prioritize maximizing wealth.

Standard recommendations on percent of Bonds to hold, amount to spend on a house or car and debt tolerance all seem like they aim in this direction for the average investor, but fall well short on the margins (high wealth, low income, and of course doctors who have their own unique financial profile).
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Re: Implicit assumptions and game theory in personal finance

Post by MrNarwhal »

A common assumption (implicit or explicit) is that savings from wage income will be held until the start of a "retirement" period without wage income and then withdrawn until death to cover expenses - unless specifically earmarked for other planned expenses (car, house down payment, etc.)*

That may be a good assumption for most people here but I do think there are other possibilities depending on personal values.

*Most people here (though not all) also subscribe to the idea of an "emergency fund" typically designed for the "emergency" of unexpectedly losing wage income for x months.
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Re: Implicit assumptions and game theory in personal finance

Post by barnaclebob »

One implicit assumption that I make is that there is no point in planning for gloom and doom economic/social order collapse. A: the govt will do anything that it can to keep the status quo and B: if I'm ever worried about where my next meal comes from there is nothing that I could do now that will make that situation tolerable. In a widespread recession where things get more expensive or income levels drop, we'll fare better than the vast majority of the population.
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Re: Implicit assumptions and game theory in personal finance

Post by avalpert1 »

barnaclebob wrote: Mon Jun 10, 2024 10:01 am One implicit assumption that I make is that there is no point in planning for gloom and doom economic/social order collapse. A: the govt will do anything that it can to keep the status quo and B: if I'm ever worried about where my next meal comes from there is nothing that I could do now that will make that situation tolerable. In a widespread recession where things get more expensive or income levels drop, we'll fare better than the vast majority of the population.
A related implicit (and incorrect) assumption people make is that a prolonged period of poor investment returns can only be associated with a period of economic/social order collapse...
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Re: Implicit assumptions and game theory in personal finance

Post by barnaclebob »

avalpert1 wrote: Mon Jun 10, 2024 10:23 am
barnaclebob wrote: Mon Jun 10, 2024 10:01 am One implicit assumption that I make is that there is no point in planning for gloom and doom economic/social order collapse. A: the govt will do anything that it can to keep the status quo and B: if I'm ever worried about where my next meal comes from there is nothing that I could do now that will make that situation tolerable. In a widespread recession where things get more expensive or income levels drop, we'll fare better than the vast majority of the population.
A related implicit (and incorrect) assumption people make is that a prolonged period of poor investment returns can only be associated with a period of economic/social order collapse...
Yep but my relative place in the pecking order will stay approximately the same even in the event of long term poor performance of the market.
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Re: Implicit assumptions and game theory in personal finance

Post by rockstar »

Going to address how I’m currently thinking about buying versus renting versus owning.

Some definitions first:

Buying: currently paying a mortgage.
Renting: currently paying rent.
Owning: currently paid off mortgage.

The three are very different depending on where you live.

For myself, when thinking about inflation, this is how it is in my part of the country.

Buying: better than CPI-U
Renting: worse than CPI-U
Owning: close to CPI-U but could be worse.

Let me explain. If you’re currently paying a mortgage as an expense item, the two pieces that will impact you inflation wise are property taxes and insurance. The rest of your payment isn’t impacted by inflation. On a proportional basis, this results in expenses growing slower than CPI-U by me. You can go through the same exercise with the other two.

The 25x rule is tough because if you’re looking at 30-35 year retirement, a few things can happen during that period. If you’re in a place that lets you freeze your property tax at a certain again, you can reduce your inflation impact. If you pay off your mortgage during that period, your expenses will go down. So your expenses aren’t really set in stone from day one. They change and your exposure to inflation changes as well.

My take away from this is to maximize liquidity and freeze as much inflation in my expenses as possible.
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Re: Implicit assumptions and game theory in personal finance

Post by upwind »

alex_686 wrote: Mon Jun 10, 2024 9:25 am
Game theory just doesn't apply to a Boglehead portfolio.
In an actionable sense probably not. Hard to see how it could.

Edit - On second thought I am not so sure the tenets of game theory aren’t in a sense applicable to boglehead investing decisions. Just think about portfolio optimization (loss minimization vs gain maximization seeking). Even though the boglehead philosophy isn’t about active investing people still talk about winning the game and this is no accident.

Things like AA, open ended bond funds vs fixed term bonds, corporate vs treasuries, diversification, inflation protected assets, tax strategies, and hedges aren’t simply the result of a toss it at the wall strategy and see what sticks. They arise from the active consideration of what individuals, governments, businesses, and other groups will or may do in an uncertain world. Some people will make these decisions actively based on the short term and others on the long term but we are all considering the behavior of others and how they effect our outcomes and how to optimize those outcomes under uncertainty.

Edit 2 - Not suggesting this paper has any direct interest to the group or that one would want to read it but just example that I am not alone in my thinking and academics have cast some of the above considerations in terms of game theory. I am not sure how useful this is or what it really adds to label it as such as it obviously only created a distraction but that’s not my point. Even I feel I am reaching and I’m not even interested in taking this position but it a technical point.

https://www.mdpi.com/2227-7072/10/1/20
Last edited by upwind on Mon Jun 10, 2024 11:46 am, edited 2 times in total.
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Re: Implicit assumptions and game theory in personal finance

Post by unwitting_gulag »

hand wrote: Mon Jun 10, 2024 9:46 am To me, biggest implicit (and often incorrect) assumption is that the goal for individuals is to maximize wealth. This is often coupled with an inexact concept of risk tolerance - how scary a roller coaster ride can one tolerate.

Maximizing wealth is easy to model, and is how many market participants operate, however is not or should not be the goal of many individuals.

Many individuals would be better served to first prevent excessively negative outcomes:


1) Assets don't drop below a minimal viable threshold for housing, food and care security + an individually determined quality of living threshold

2) Wealth generation or market fluctuations do not negatively impact health (e.g., stress) or family / community relations

Only after these priorities have been met, does it make sense to prioritize maximizing wealth. ...
Of course we have Maslow's hierarchy of needs. But even that is subjective. Much is contingent on whether a person has dependents, is part of a family or kin-group, feels a communal responsibility, feels a need to retain social standing and so on.

A family-person would presumably prioritize the safety, nutrition, education and vitality of his/her children... before trying to maximize stock market returns. We had an anecdote by one of our most venerable members here, whose parents, back during the Great Depression, had too much of their money in the stock market... resulting in the loss of the family home. That was clearly cited as a mistake, the lesson being, that a more conservative asset-allocation would have spared the family much grief, even if it didn't maximize wealth. But what if there is no family and no home? What if we have a solitary unencumbered individual, who beholds himself or herself as basically a meat-machine programmed to generate wealth? Then Maslow's pyramid collapses, or inverts.

High risk tolerance isn't the same as intense fascination with building wealth. If it were, then the wealth-minded would all be start-up founders or speculators in options or something like that. Some are. But many (most?) realize the finitude of their powers, or are just better at math, calculating expectation-integrals. Maybe some venture will potentially garner for me billions, but the probability density function is such, that when the calculation is done, the expected value is negative. However rapacious or greedy I might be, I'll desist from that venture. Maybe this is where game theory enters... players calculate expected outcomes, and "bet" accordingly.
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Re: Implicit assumptions and game theory in personal finance

Post by firebirdparts »

plsgoobs wrote: Sun Jun 09, 2024 11:08 am Thank you for the wise words. What prompted this thought was that I realized I didn't truly understand all the underlying assumptions of several of the common personal finance recommendations, while fully recognizing that personal finance is hard and the best way to teach people is to not immediately overwhelm them so they can just start. Because saving sub-optimally is far better than not saving at all.
It's a really interesting question. What jumped out at me was your list of "basics" was nothing like my list of basics, but upon further reflection I think "don't spend your money" is basic. I was really surprised about the others. Trying to understand where I am coming from and what my basics actually are. I don't want to use the phrase "implicit assumptions" because I don't see the need to admit that's what it's all about.
This time is the same
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Re: Implicit assumptions and game theory in personal finance

Post by Houseofbricks »

Applying Game Theory to Personal Finance => How can someone take advantage of predictable behaviors of other(s) of markets full of other(s)? A few thoughts:

1. Housing - Real Estate
Buy the least expensive house on your block, neighborhood. Be sure it feeds the better school(s). I see trouble where hedge funds are buying houses and renting out. Probably ok when less than 10% but not a good thing when rental exceeds 20%. More interesting are areas where hedge funds are buying large acreages and building 300 or 500 homes to rent. These houses will not do as well as broader home market as neither the owner or renter eager to put in more maintenance and investments. There will not attract as a sense of community and the value for that. When market dips, there will a push to fill with whatever renter can be had. Again schools in the area will be impacted.

2. Exec Compensation, Share Buy Back and Auto 401K purchases.
These actions look like they will put a floor on individual share prices but I've seen companies overpaying at market tops and cash poor when economies turn down. This behavior in the near turn could swing markets more in the short term but flatten them in the long term. For retiree looking for that safe withdrawal rate, I actually seeing more risk can be taken.

3. Jobs Report
We have two sets of jobs reports that have been diverging over the last couple of years. There's the Establishment Survey which the markets follow and react on, and there's the Household Survey which has been has been painting more pessimistic jobs front and economic look. Mainly, a chunk of jobs have shifted from permanent to part time, probably lower paying.
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Re: Implicit assumptions and game theory in personal finance

Post by unwitting_gulag »

Houseofbricks wrote: Wed Jun 12, 2024 11:06 am Applying Game Theory to Personal Finance => How can someone take advantage of predictable behaviors of other(s) of markets full of other(s)? A few thoughts:

1. Housing - Real Estate ...

2. Exec Compensation, Share Buy Back and Auto 401K purchases. ...

3. Jobs Report ...
These "game theoretic" strategies run into the Efficient Markets Hypothesis. The more that we believe EMH, and the stronger the form of EMH in which we believe, the less of a game-theoretic advantage remains, for astute players. That is, a strategy to do this-or-that, in reaction to observed behavior of other players, becomes less and less useful, the reaction of other players becomes instantaneous, and the inputs to our strategy change, as it were, instantaneously. We find ourselves in a position, as if we had no knowledge of what is happening in the game. Thus the rationale behind index funds, and buy-and-hold.

The less efficient the particular market, the higher our chances of finding a profitable game-theoretic strategy. In the limit, a "perfectly inefficient" market is one where the other players are obtusely ignorant of how the game works. They play at random, or according to emotion, or some bogus heuristic. The advantage is with the player who has figured out the table-of-outcomes and has found (ideally) the strictly-dominant strategy.

It stands to reason, that the more local and idiosyncratic a market, the more likely there's room for inefficiencies. The stock market is global, and so, is likely to be the most efficient. The real estate market is by definition local. So, of your list, I think that item #1 is the most exploitable. Unfortunately, it is also the most likely to trap us in a blunder! If we have the wrong strategy in the game, we will lose, because another player will be more astute and more systematic and better informed and so on. Inefficiency is double-edged. Do we feel lucky?
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Re: Implicit assumptions and game theory in personal finance

Post by plsgoobs »

upwind wrote: Mon Jun 10, 2024 11:31 am Edit 2 - Not suggesting this paper has any direct interest to the group or that one would want to read it but just example that I am not alone in my thinking and academics have cast some of the above considerations in terms of game theory. I am not sure how useful this is or what it really adds to label it as such as it obviously only created a distraction but that’s not my point. Even I feel I am reaching and I’m not even interested in taking this position but it a technical point.

https://www.mdpi.com/2227-7072/10/1/20
Thank you, upwind. I didn't see this paper in my quick search!
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plsgoobs
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Re: Implicit assumptions and game theory in personal finance

Post by plsgoobs »

unwitting_gulag wrote: Wed Jun 12, 2024 11:19 am
Houseofbricks wrote: Wed Jun 12, 2024 11:06 am Applying Game Theory to Personal Finance => How can someone take advantage of predictable behaviors of other(s) of markets full of other(s)? A few thoughts:

1. Housing - Real Estate ...

2. Exec Compensation, Share Buy Back and Auto 401K purchases. ...

3. Jobs Report ...
These "game theoretic" strategies run into the Efficient Markets Hypothesis. The more that we believe EMH, and the stronger the form of EMH in which we believe, the less of a game-theoretic advantage remains, for astute players. That is, a strategy to do this-or-that, in reaction to observed behavior of other players, becomes less and less useful, the reaction of other players becomes instantaneous, and the inputs to our strategy change, as it were, instantaneously. We find ourselves in a position, as if we had no knowledge of what is happening in the game. Thus the rationale behind index funds, and buy-and-hold.

The less efficient the particular market, the higher our chances of finding a profitable game-theoretic strategy. In the limit, a "perfectly inefficient" market is one where the other players are obtusely ignorant of how the game works. They play at random, or according to emotion, or some bogus heuristic. The advantage is with the player who has figured out the table-of-outcomes and has found (ideally) the strictly-dominant strategy.

It stands to reason, that the more local and idiosyncratic a market, the more likely there's room for inefficiencies. The stock market is global, and so, is likely to be the most efficient. The real estate market is by definition local. So, of your list, I think that item #1 is the most exploitable. Unfortunately, it is also the most likely to trap us in a blunder! If we have the wrong strategy in the game, we will lose, because another player will be more astute and more systematic and better informed and so on. Inefficiency is double-edged. Do we feel lucky?
Oh the Efficient Markets Hypothesis is an interesting counter to the idea of defining a game with regards to the market. I admittedly didn't think about that. Thank you for your thoughts. I like the idea of the application of game theory applying to inefficiencies, but isn't the assumption that those inefficiencies are relatively short lived given the market's information flow? So any strategy might only last for a short period before being adopted by a greater number and the effects diluted?

The local housing market is where I first was thinking about game theory's application to personal finance because the size of the market and number of players is inherently limited and the information flow is slower. Perhaps it's less relevant to picking individual stocks.
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Re: Implicit assumptions and game theory in personal finance

Post by unwitting_gulag »

plsgoobs wrote: Sat Jun 15, 2024 7:47 am
unwitting_gulag wrote: Wed Jun 12, 2024 11:19 am
Houseofbricks wrote: Wed Jun 12, 2024 11:06 am Applying Game Theory to Personal Finance => How can someone take advantage of predictable behaviors of other(s) of markets full of other(s)? A few thoughts:

1. Housing - Real Estate ...

2. Exec Compensation, Share Buy Back and Auto 401K purchases. ...

3. Jobs Report ...
These "game theoretic" strategies run into the Efficient Markets Hypothesis. [cut]
Oh the Efficient Markets Hypothesis is an interesting counter to the idea of defining a game with regards to the market. I admittedly didn't think about that. Thank you for your thoughts. I like the idea of the application of game theory applying to inefficiencies, but isn't the assumption that those inefficiencies are relatively short lived given the market's information flow? So any strategy might only last for a short period before being adopted by a greater number and the effects diluted?

The local housing market is where I first was thinking about game theory's application to personal finance because the size of the market and number of players is inherently limited and the information flow is slower. Perhaps it's less relevant to picking individual stocks.
One supposes that the Wall Street big-brains adopted game theoretic ideas to their trading strategies shortly after the theoretical game-theory revolution, in the 1940s and 1950s. It would have been especially useful then, there being less information-flow at the time, and more ease of exploiting things that weren't instantly known in-mass. So, we're about 75 years too late.

But I'd imagine that any individual real estate transaction can be beheld in game-theoretic terms... how to negotiate, vie with other bids, score the best possible deal, avoid overbidding and so on. Savvy buyers probably do this already, intuitively, without having (or needing to have) any mathematical model. I wouldn't be surprised if there were real estate books already discussing this.
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