The stock market further traversed its high wire act this week. Tiptoeing along, while trying to not look down.
Congress even reopened the government – until January 30. That way members can kick back over the holidays before they return to Washington, where they’ll once again pretend to do real work after the New Year.
For sensible investors, staring down extreme valuations and mounting uncertainty, there’s little out there to grab onto. Given these prospects, what can a savvy investor do to find something – anything – that feels genuinely certain?
To answer this question, let’s turn to one of the greatest minds of the 20th century. A Renaissance man named John von Neuman who shaped everything from quantum mechanics to digital computing, and the development of the first American atomic and hydrogen bombs.
Von Neumann was born in Budapest in 1903 and studied in Berlin at a leading scientific institution; one that considered Einstein unqualified for a research grant. He’s also referred to as “the founder of game theory,” and could multiply eight digits by eight digits in his head.
But beyond the abstract math and algorithms, and his love for telling ribald jokes and reciting off-color limericks, von Neumann had a fiercely practical approach to problem-solving. This pragmatic worldview gives us a powerful framework for navigating today’s confusing market.
There’s a classic anecdote about von Neumann that boils his philosophy down to its very essence. When asked to define certainty his answer was centered on an example of radical practicality. It wasn’t abstract or academic. It was simple to understand and tangible.
He said that to achieve certainty, you must first design a house and ensure the living room floor will not give way. To do that, you must:
“Calculate the weight of the grand piano with six men huddling over it to sing. Then triple that weight.”
That will guarantee certainty.
From Piano Floors to Probability
Think about the simplicity of that statement. Certainty, for von Neumann, wasn’t the absence of risk. It was the extreme overcompensation for every possible risk.
It wasn’t about building a floor just strong enough for the expected load. It was about building a floor strong enough to handle an improbable party, a rowdy sing-along, and then multiplying that stress by a factor of three.
This could be applied to your investments in terms of the ultimate stress test where you build in a safety margin to the power of three. When looking to build wealth in an overvalued market, like now, this idea is worth your consideration.
The piano story may be a simple anecdote. But it also captures von Neumann’s serious academic contributions to probability and Game Theory.
In 1944, von Neumann co-authored Theory of Games and Economic Behavior with economist Oskar Morgenstern. This groundbreaking work established game theory as a distinct field. At its core, game theory is the mathematical study of strategy and decision-making when the outcome of your choices depends on the choices of others.
Von Neumann focused on how rational players can arrive at the best possible outcome (the Nash Equilibrium, though named later, is based on these concepts) in situations where information is incomplete and competitive actions are involved.
But here is where his work intersects with the piano story. Von Neumann saw that in any complex arrangement – a duel, a poker game, or an economy – you cannot merely calculate the most likely scenario. You must calculate the worst reasonable scenario and then design your strategy to survive it.
Our “Maximum Load” Scenario
For investors, this means two things:
First, probability is not necessarily destiny. Just because the market is most likely to keep going up over the long term doesn’t mean you should bet your life on that single probability.
Game theory forces you to consider competing moves. Things like the unexpected inflation spikes, the unforeseen geopolitical events, world wars, the mass panic selloffs.
Second, there’s the Minimax Strategy. A key concept in von Neumann’s zero-sum game theory is the Minimax theorem.
In simple terms, a rational player seeks to minimize their maximum possible loss. They don’t aim for the highest return. They aim to avoid catastrophic ruin.
The grand piano story is just Minimax applied to structural engineering: Minimize the maximum chance of the floor collapsing.
Right now, we are in a market that is extremely overvalued. Whether you look at the Shiller P/E Ratio (or CAPE), Price-to-Sales, or even the market capitalization to GDP. The stock market, as a whole, is trading well above historical averages. The “load” on the foundation of the stock market – i.e., the expected future earnings supporting current prices – is already heavy.
If the expected load is already heavy, what is the tripled load? What is the worst-case scenario we must overcompensate for?
It’s not just a minor correction. It’s a perfect storm of systemic stress.
A prolonged recession that causes a long-term decline in corporate earnings. Persistent high inflation that forces interest rates upward. The abrupt de-rating of high-flying growth stocks, priced for perfection, which causes them to fall back to earth.
What if all three of these scenarios happen simultaneously?
How to Use Game Theory to Protect Your Wealth
The goal of investors applying von Neumann’s framework isn’t to pick the stock that will go up 200 percent. Rather, it’s to construct a portfolio that won’t collapse when the market takes a nose-dive.
From a practical sense, this involves companies that are cash rich. Do they have enough cash on hand to survive not just one year of bad earnings, but three years?
If the economy freezes, will they still be able to service their debt and fund operations? If interest rates suddenly tripled, could the company still easily pay its obligations?
This also requires being brutally pessimistic when considering a company’s fair value. What would happen if the company only grew its earnings by 5 percent per year instead of the assumed 15 percent?
Extreme diversification is also requisite. This goes beyond just buying stocks from different sectors. It includes buying different asset classes. Cash, commodities, gold, and even some real estate holdings.
Certainty, as defined by von Neumann, is an action taken, not a state granted. It is the active decision to overbuild, over-save, and over-prepare for the absolute worst.
Investing, no doubt, is a cutthroat game. Von Neumann’s work provides a rulebook for survival.
So, if you’re tempted to chase the latest high-flying stock based on the flimsy story of an AI revolution bringing unlimited growth, remember the grand piano. Calculate the absolute maximum stress that economic reality could place on that company’s earnings, its valuation, and its industry. Then, triple that stress.
If the stock – or your portfolio – can not only survive that test but is priced cheap enough to thrive after the collapse, then and only then, have you achieved the kind of certainty John von Neumann would approve of.
An overly pessimistic framework?
Perhaps. But with today’s extreme valuations and economic fragility, actively preparing for the absolute worst economic outcome is a must.
[Editor’s note: Join the Economic Prism mailing list and get a free copy of an important special report called, “Utility Payment Wealth – Profit from Henry Ford’s Dream City Business Model.” If you want a special trial deal to check out MN Gordon’s Wealth Prism Letter, you can grab that here.]
Sincerely,
MN Gordon
for Economic Prism
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