Keynesian beauty contest – behavioural finance

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

 

Keynesian beauty contest - behavioural finance

 

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

 

The voting is now closed. You can see the results of the Keynesian Beauty Contest voting.

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Comments

  1. says

    You know what, the commenting system in this blog is not conducive for this experiment (since the commenter can see all the previous entries and increase his chances of winning with going with the maximum voted candidate).

    A poll widget from surveymonkey or polldaddy would be better! It shows results AFTER you have chosen!! My vote – Katrina Kaif :p

  2. Akbar says

    Nice article Kunal..
    I will go with my favourite YAMI GAUTAM.
    One for the furture.. soon people will realise..
    C’mon people.. vote for YAMI.. we will win the game.

  3. says

    Kidakaka – thanks for the suggestion have implemented it. You can use the surveymonkey voting system now.

    Akbar – Thanks. And yes, Yami Gautam was my personal choice if there was a simple beauty contest instead of a Keynesian beauty contest. Our views match.

    Pranav – thanks for voting.

    All those who voted in the comments, do use the new voting system. Thanks!

  4. Anil Kumar Tulsiram says

    Excellent article.

    This reinforces the point that invest in a company either when you think there is a catalyst for re-rating [3months to 3 years time frame] or you will not be worried even if stock market closes for next five years or world enters into depression and prices remain depressed for extended period of time [companies with strong entry barriers, honest management and low leverage , both operating and financial].

    • says

      I agree with you Anil.

      I am ok with value investing. But I am not ok with some people saying that they are ok with waiting forever to realize the convergence of fair price and value. There is an opportunity cost to waiting.

      If we can find triggers or causes for others to understand the value then its always a better investment.

      • Nikhil Moryani says

        Hi Kunal,

        You’ve articulated the idea of ‘Be where the puck is going to be.’ very well. I think, sustainable growth in earnings is the only value driver which everyone can see easily and jump to own a piece of it.

        • says

          Hi Nikhil,

          I agree with your first sentence. It summarizes the Keynesian beauty contest.

          I actually disagree on your second statement.

          Look around you and mentally parse through the list of people that you know who invest in the market. How many invest in a stock without even knowing what the company does? Earnings come much later in the list of questions!

          I suspect most retail investors don’t get into details at all. Sadly, this is why they also make mistakes. That is why I feel that earnings is not something that everyone can “see” as you say. There are many who don’t bother and they too are part of the same stock market.

          An alternative view is that there are ample no. of people who follow momentum driven stocks and make money too. They don’t care about earnings. They follow price trends, up or down.

          In summary, whatever works for you is good, if there is a method to it that can be applied consistently and generates returns as per your expectation.

          Regards,
          Kunal

  5. Nikhil Moryani says

    Yeah,Kunal. Agree,majority of the market participants do not study or understand the business but I was talking about people who come before such people,people who like to understand the characteristics of the business and try to ascertain a price at which to buy. For them,earnings growth is relatively easily to understand and jump on the opportunity. We’ve seen this in a lot of 200-300 cr market cap cos. that have now become 2x,3x or may be 10x. As the growth story is validated,more and more people want to own the business even if they have to pay an expensive price given growth is still to come.

    May be,this is kind of a Keynesian Beauty Contest for the Value Investors. :)

    • says

      Oh yes! Earnings growth works wonders for valuation for a lot of small and mid caps. Sometimes I wonder how many of us have the foresight to see the value in future growth. I include myself in that too. It is not easy!

      • Nikhil Moryani says

        Kunal,what makes you say it’s difficult?? My entire investing philosophy/understanding (whatever it is till now) revolves around growth at a reasonable price,highly influenced by Lynch andFisher. May be your view about difficulties involved could help me avoid pitfalls and make me tread with caution.

        • says

          Mid and small caps essentially have low coverage. Fact gathering is that much tougher. Track record of management is tough to examine threadbare unlike larger companies. You might see positives in the financials but the reasons for the positives are tougher to verify.

          From the past to extrapolate is incrementally tougher in smaller companies. Plus for the fact that they are more prone to shock (sector or company level reasons) as compared to larger companies.

          I meant that for small and mid caps.

          That said, if you can get a grip on a small cap company you stand to make much more money typically than a large company if your entry valuation is good.

          I like the mid cap and small cap space myself. Most of my holdings are in this area. It’s challenging but has a lot of promise. :)

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