Bats and Brokers

Quick! The market is crashing, and you are overextended, so where do you turn for help: a) your broker or b) a bloodsucking vampire bat? Yes, the correct answer is b. Through trial and error over many eons, these bats have devised a market for blood that allows a bat to call on other bats when they find themselves with a temporary liquidity crisis. By contrast, when investors faced margin calls during the market free fall on Tuesday, brokers dumped customers' stocks, inflicting pain on clients and accelerating the downdraft. The vampire-bat comparison may be comical, but it points to a vulnerability of today's markets that should give pause to investors who play the market swings.

While it makes perfect sense to be the first person to sell in a rout, when everybody comes to that conclusion, everybody loses. The vampire-blood exchange, described by biologist Gerald Wilkinson in 1983, caught the attention of economists because it represents a natural occurrence of the optimal solution to a problem called "the Prisoner's Dilemma" that has bedeviled game theorists for decades.

The game poses a situation in which a prisoner who sells out his accomplice stands to benefit from leniency, unless his accomplice separately sells him out as well. The third option is that neither sells the other out, and each serves a sentence longer than if he had, but shorter than if he himself had been sold out. What's the best thing to do? Robert Axelrod, a political scientist at the University of Michigan, tested various strategies over a number of years and discovered that as the game is repeated over and over, a simple strategy of tit for tat tends to win: if someone gives you something, reciprocate; if no one does, don't. That's what the bats do.

Axelrod found that players are most apt to gravitate to this system when they are likely to encounter the other players again. Without this "shadow of the future," there is every incentive to cheat--to drink but not share blood or, in the case of the stock market, to dump your shares at the first sign of a panic. So the larger and more anonymous the situation, the greater the incentive to be selfish.

There is no more anonymous forum than the stock market. It's predicated on the notion that the greater good for all will come from many individuals who have the opportunity to act on their immediate self-interest. Unfortunately, when seas get rough, there is nothing to stop investors from sinking the lifeboats in their zeal to abandon ship. Robert Shiller, author of Irrational Exuberance, which explores the perils of the present market, once devised a survey to probe whether investors felt any responsibility to the overall system. When asked whether they might reduce selling in a crash out of a sense of social responsibility, only 8% of 123 institutional investors responded yes.

Couple this with the increasing tendency of investors to act in lockstep, and you have a prescription for future episodes in which liquidity dries up. Individuals who plan to hold their shares for years needn't worry, but those who believe they can jump out at the first sign of trouble would do well to ponder last Tuesday's brief but terrifying free fall. They might also rethink the wisdom of buying stocks on margin in today's take-no- prisoners market.

Contributor Eugene Linden is the author of The Future in Plain Sight. You can e-mail him at daily@pathfinder.com