This article will take you through a great way to understand how the stock market functions.

Never expected to see a bevy of beautiful faces on a website that teaches you about investing? No, I am not turning this into the next Bollywood focused site.

There is a thought experiment that we are going to play now.

Some background first.

Lord Keynes was a famous economist. A lot of the policies that are being followed in different economies after the credit crisis struck in 2008 are called “Keynesian” policies. Of the many areas he wrote and spoke on, Lord Keynes recommended certain policies to be undertaken when an economic crisis is upon a country. Not that there are detractors. The Austrian school of economics differs from many Keynesian prescriptions.

Keynes proposed this thought experiment.

Enter the Keynesian beauty contest

Take a look at the faces shown above.

This contest has the following rules.

1. You have to select one face as the most beautiful among the choices given.
2. The face with the maximum votes wins.
3. All the participants who have voted for the winner get a prize.

Imagine that there are hundreds of people playing this Keynesian beauty contest.

Who do you vote for?

You broadly can have 2 lines of thought.

One, I will vote for the face that I consider most beautiful.

Two, I will vote for the face that I think most will consider beautiful.

If you consider the second option of selection, you have a better chance of collecting your prize.

In the first option, you might get a sense of self-satisfaction of sticking to what your mind said. You were not swayed by what other people think. But there is no denying that your chances of walking away with a prize are lesser than when you follow the second option.

Lord Keynes says

It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

 

Keynesian beauty contest and stock markets

You might already have seen the parallels of this contest with the stock market.

You might see that a particular stock or instrument is undervalued. That its fair value as you have computed or analyzed is higher than the market price.

You might be right and invest. Till other players in the market do not realize the undervaluation, the market price will not go higher and converge with the fair value.

Reverse the logic for overvalued stocks and you will see that overvaluation may persist if many do not realize it.

If you have understood Keynes’ words you will accept that “realize” is now a loaded word.

You might think to higher degrees like Keynes said. You might know that what others think is wrong. You might try to ride higher on an overvalued stock because prices are going ever higher. You persist because you want to go with the flow.

This is also possible and you can make money in this manner. Just that is more unsafe, because you don’t know when to exit. You can fall of a price cliff.

Benjamin Graham says

In the short run, the market is a voting machine but in the long run it is a weighing machine.

Benjamin Graham is considered by many to be the father of value investing.

What this says is that in the short-term, attitudes and expectations matter relatively more in stock prices. In the long-run, the fundamentals of a company drive prices.

In the short-term there might be significant deviations of price from fair value both on upside (overvaluation) or downside (undervaluation). You already saw that it can happen when you played the Keynesian beauty contest.

Let us vote now

Let us play this contest. It will be interesting to see the results. There is one catch though. Here what you type will be seen. I trust that you will be honest and not be swayed by the previous comments when you type yours.

Update – I had earlier asked you to use comments. I took kidakaka’s suggestion and added a voting system. Please use it instead of the comments area.

You have to choose between.

1. Bipasha Basu
2. Aishwarya Rai
3. Priyanka Chopra
4. Katrina Kaif
5. Kareena Kapoor
6. Yami Gautam

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