I’m taking a break from the medical aid series to share two things this morning.

Thing 1: This Great Youtube Clip on the Prisoners’ Dilemma

If you’re reading this in your inbox, you can watch the clip directly on rollingalpha.com.

Two screencaps:

The conclusion has not changed:

1. The group would be better off if everyone co-operated.
2. Individually though, neither person has any incentive to co-operate.
3. From Ms Red’s perspective, Mr Blue will either co-operate or defect, so:
   1. If he co-operates, then she should defect and spend zero years in prison (as opposed to a year in jail if she co-operates).
   2. If he defects, then she should defect and spend two years in prison (as opposed to three years in jail if she co-operates).
4. That is, regardless of what is good for the group: what is best for the individual is defection.

The reason I’m sharing it here is because I think that the clip does a particularly nice job of linking the dilemma to the real world (of advertising).

Thing 2: “Smart” Pessimists

Cullen Roche’s newsletter this morning made reference to this article on the Motley Fool: “Why Does Pessimism Sound So Smart?” I think it’s worth a read.

Some highlights:

John Stuart Mill wrote 150 years ago: “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.” Matt Ridley wrote in his book The Rational Optimist:

“If you say the world has been getting better you may get away with being called naïve and insensitive. If you say the world is going to go on getting better, you are considered embarrassingly mad. If, on the other hand, you say catastrophe is imminent, you may expect a McArthur genius award or even the Nobel Peace Prize.”

In investing, a bull sounds like a reckless cheerleader, while a bear sounds like a sharp mind who has dug past the headlines – despite the record of the S&P 500 rising 18,000-fold over the last century.

And:

Pessimists extrapolate present trends without accounting for how reliably markets adapt. That’s important, because pessimistic views often start with a foundation of rational analysis, so the warning appears as reasonable as it is scary.

In 2008, environmentalist Lester Brown wrote: “By 2030 China would need 98 million barrels of oil a day. The world is currently producing 85 million barrels a day and may never produce much more than that. There go the world’s oil reserves.”

He’s right; We’ll run out of oil in that scenario. But that’s not how markets work. A shortage pushed up oil prices, high prices incentivized producers to come up with new drilling techniques, and now we have more oil than we know what to do with. World oil production last year was 96 million barrels — already way above what he thought was the high mark. Failing to account for markets’ ability to adapt is the cause of death of most pessimist forecasts.

Should you ever listen to pessimists? Of course. They’re the best indication of what’s unsustainable, and thus probably about to change, and thus the soil of what’s to be optimistic about.

Putting “two” and two together

Whether or not I intended it, I have my own link to draw between those two things.

The choice between being a market optimist and being a market pessimist is also a bit of a prisoners’ dilemma.

Take Ms Red and Mr Blue. Assuming that they’re both market analysts:

1. If both Ms Red and Mr Blue are optimistic about the market, then they’re treated with mild suspicion by everyone – but at least if they’re wrong, they’re not alone in facing the investors that lost money.
2. If both Ms Red and Mr Blue are pessimistic about the market, they’ll be treated with more intellectual respect. And if they’re both wrong, then at least no one invested and lost (maybe just some opportunity cost – which is mostly unquantifiable and vague).
3. If one of them is pessimistic and the other is optimistic, the optimist will be treated like a fool, while the pessimist will be called a sage. And if the optimist is wrong, then they’ll be discredited forever. And if the pessimist is wrong, then the market will tend to respond by saying that “he’s not wrong – he’s just not right yet”.

That is, individually, the clear incentive is to be a pessimist.

*cough* Apple analysts *cough*

Have a great Wednesday.

Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.