LinkedIn, bubbles and game theory

LinkedIn shares have rocketed up since they started trading and are now at around $100 per share. This values the company at about $10bn or 25 times revenue, this compares to Google which is valued at six times revenue.

Clearly this looks like a bubble, but, from a game theory perspective, why do we get bubbles in the first place?

In this situation investors are not making their decisions based on what they really think the company is worth, they are basing it on what they believe other people will do. Whilst they believe that other people will pay more for it then they are willing to buy, whatever the price. Of course, someone is finally left holding the shares when the confidence disappears.

We can see a game theory analogy to this. Soccer programmes often run a ‘goal of the month’ competition. You can enter the competition by picking your top three goals from a choice of ten. Those goals that receive the most votes will be announced as the top goals of the month. If you match the top three then you are entered into a draw for a prize. Some players will just choose their favourite goals. Others will be trying to win and therefore choose goals that they think other people will choose. A few will even go to the next level and choose goals that they think others will think others will choose. And so on…

This compares to the stock example where I will buy shares if I think someone else will pay me more for then in the future. I know that for them to pay me more they must believe that someone else must pay them more, and so on.

Anyone who thinks this through enough levels will realize that eventually there will be no more buyers left. Once someone reaches this conclusion then the whole chain collapses and it does not make sense to buy. The smartest investors like Warren Buffett avoid bubbles, others think that they will be quick enough to get out just before the final stage when the bubble pops.

People naturally fall for the temptation of easy money from a bubble but game theory shows that you should never get involved in the first place.

Never make investment decisions just on the belief that someone else will pay more, base your decisions on the fundamentals.

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