In investment management, the game theory developed by the three latest Nobel Memorial Prize winners in economics has only begun to become understood as a powerful yet still remote tool.
Its applications - most still only potential but a few in implicit use - range from explaining the macroforces shaping interest rates and economies worldwide to providing microeconomic lessons in individual portfolio trading strategies for stocks and bonds.
In a more accessible application, game theory offers insights to fundamental securities analysis, said Stephen Ross, co-chairman of Roll & Ross Asset Management Corp., Blue Bell, Pa., and a professor in economics and finance at Yale University.
It "fundamentally alters how we think about companies' operating strategies ... how companies compete with each other," he said. "I think this will change how we do fundamental analysis."
But "It's not the kind of thing you use every day in investing," said Paul Kaplan, chief economist, Ibbotson Associates Inc., Chicago.
Game theory has much more profound uses in describing the economy and business activity.
The Nobel Memorial Prize in Economic Sciences, the first for game theory, honored John Nash, a mathematician and visiting research collaborator at Princeton University, Princeton, N.J.; John C. Harsanyi, professor emeritus in economics at the University of California, Berkeley; and Reinhard Selten, professor of economics at Rheinische Friedrich-Wilhelms-Univeristat in Bonn, Germany.
"The Nobel prize this year was given for work of a far more profound and important nature than any other in economics," said Horace W. "Woody" Brock, president, Strategic Economic Decisions Inc., Menlo Park, Calif., who knows and has worked with Messrs. Harsanyi and Selten.
"These people have made it possible to explain," Mr. Brock said, such forces as "how a cartel like OPEC - the Organization of Petroleum Exporting Countries - comes into existence and dies," or "to decipher the signals a company like General Motors Corp. may send to other automobile manufacturers."
"A cartel like OPEC has had more implications for interest rates than all the other things put together," he added, while the competitive strategy of a powerful corporation like GM reveals insights useful for fundamental analysis in portfolio management.
Their pioneering game theory work brings a realistic description of human interaction in competition and bargaining. It contributes to the understanding of both macro- and microforces in the economy and in particular business and market activities, from corporate takeovers to competitive strategies.
Still, Mr. Brock acknowledged most economists would find game theory difficult to grasp.
Mr. Ross said, "Relative to some other things, it's probably a bit remote" from portfolio management. On a scale of one to 10, with 10 being widest impact on applications, I'd give it a two or three."
None of those interviewed knows of any investment advisers applying game theory.
Their prize for more remote game theory work stands in contrast to the 1990 Nobel Memorial Prize in economics won by William F. Sharpe and Harry Markowitz and Merton Miller for their work in, respectively, modern portfolio theory and the cost of capital, both widely applied in investment and finance.
Remarking on game theory, Mr. Sharpe, finance professor at Stanford University, Palo Alto, Calif., said, "It's still pretty abstract stuff."
He said game theory's influence in the investment industry is still to come, noting, "There is a lot of useful work on game theory in economics." At First Quadrant Corp., Pasadena, Calif., David Leinweber, director-research, said, "It's not like it's used every day like Sharpe or Markowitz.
"But it is becoming an increasing part of thinking in investments."
Unlike modern portfolio theory, their game theory doesn't describe the stock and bond markets, although it has a use in investing.
"The financial market aren't game theoretical," Mr. Brock said. "In financial markets, activity is usually assumed to be perfectly competitive," with thousands of competitors, where no one person or entity can exert a profound influence.
"But the external factors" - such as government policy or corporate competitive strategies - "are indeed game theoretical." So investors can use game theory to enhance fundamental analysis for security selection, he said, as Mr. Ross also noted.
"Game theory has no relation to Sharpe or Markowitz or Miller," Mr. Ross added. Their work is a model of perfect competition.
"But at the structural level" - how individual companies, say, compete with each other - "game theory is useful to investors."
In trading stocks and bonds, portfolio managers use game theory in an implicit way, said Peter L. Rathjens, senior manager of research, PanAgora Asset Management, Boston.
Traders implicitly use game theory to sort out strategies to trade large blocks of stocks, he added. They "play a game" of trading without revealing too much in their possession to trade or paying or giving up too much in price to complete a deal.
But Mr. Brock calls trading a "more trivial, less interesting" application of game theory, considering its more profound uses.
