John Maynard Keynes is known as an excellent economist for his work titled “The General Theory of Employment, Interest, and Money.” Many renowned economists do not agree with what Keynes has said. Regardless of his economic theories, unbeknownst to most is the fact that Keynes was one of the greatest investors of his time (1883 – 1946). Keynes was one of the first to recognize that investing is an exercise in mass psychology.
Keynes Beauty Contest
The Keynesian Beauty Contest is a concept developed by the late John Maynard Keynes to explain price fluctuations in the stock market. According to Keynes, investors do not make money by picking the best companies; they make money by picking stocks of companies that other investors will want to buy. The analogy was based on a contest run by a London newspaper where entrants were asked to choose a set of six faces from 100 photographs of women that were the most beautiful. The rules for the beauty contest were as follows:
- Each participant had to pick, not those faces which he (or she) finds prettiest, but those which he thinks likeliest to catch the fancy of the other participants.
- The prize was awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.
According to Keynes:
“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 practise the fourth, fifth and higher degrees.’ (Keynes, General Theory of Employment Interest and Money, 1936).”
Keynes used the beauty contest as a proxy for describing the behaviour of investors in the stock market. I think that most of us are now engaging in the conduct that Keynes alludes to. Consider the following:
- Many websites (and WhatsApp groups) glorify the latest exploits of investors who seem to be on a winning streak. Most of the stuff is pretty dated. These unverified write-ups of high-profile investor entries and exits do lead to an almost immediate volatility in the prices of the underlying. Effectively, investors are motivated to guess what the other investors are doing to profit from short-term price movements. In other words, investors at different levels of the ‘investor pyramid’ are trying to second-guess or third-guess what the other guys (or gals) did.
- How does this affect price discovery? Investors aren’t looking for outstanding businesses or investing ideas. What we are looking for are stocks that other people believe still other people would want to buy. It does lead to herding and groupthink. As more and more of us participate in the ‘beauty contest,’ prices will tend to depart from their intrinsic value. In such a scenario, the fundamentals don’t matter, or instead, they progressively cease to matter. Effectively, rising stock prices seem to have become the only justification for owning a stock. Conversely, falling stock prices of shares in the Technology and Pharmaceutical sectors are the reasons for not owning these names.
- In an information-obsessed world, most of us are now keen on gaining an informational edge, rather than focusing on what matters (like fundamentals, earnings, etc.). The more information we manage to accumulate, the more confident we are; that doesn’t necessarily mean that we are correct. Inevitably, we end up investing based on stories. Stories can be misleading and more often than not, differ materially from what the facts are.
To conclude, stock market investors are always engaging in the behaviour described above. As a result, investors in the stock market tend to price shares not based on their fundamental value, but by what everyone else thinks their value is or what everyone else would predict as their real value. The fact that the current bull market has been pretty one-sided (thus far) has led to this ‘beauty contest’ behaviour becoming even more rampant and hence glaringly obvious.
When’s the Crash?
It is a fact that investor sentiment plays a significant role in the price discovery process. The advent of behavioural science has meant that this is now common knowledge. As a result, most of us are currently participating in another beauty contest – trying to guess sentiment. The sentiment is intangible and cannot be objectively measured. Hence, it is next to impossible to predict swings in sentiment indices. Trying to guess what the mass psychology currently is and then trying to imagine, ahead of time, how sentiment will fluctuate, is in a way tantamount to making a forecast. As a result, I don’t have a direct answer to the rhetorical question, “When’s the Crash.” Different strokes for different folks, there’s nothing right or wrong about the stock market game; my thoughts, take your pick:
- Extremes in sentiment will inevitably lead to a bubble and then a crash in the indices. That is why almost everyone is obsessed with trying to gauge investor sentiment. Can markets crash due to external factors? Historically that has never happened. Extremes in investor sentiment have accompanied every crash. The bull case is that since there are no signs of euphoria, the probability of a crash in the indices are remote. Irrespective of what one’s perceptions of what sentiment is, should one be complacent or cautious? There is always a first time for everything, maybe this time markets might crash without the euphoria, due to some external factors, who knows? Or perhaps, since everyone is obsessed with what the mass psychology is, we might all be wrong-footed and be caught looking in the wrong direction. On battlefields, they say that the shell that gets you is the one you don’t hear coming. Net-net, caution is warranted, cash is an asset class all by itself. Cash is popularly called financial valium, it keeps an investor cool and calm.
- Momentum, Momentum, Momentum! Why worry about the inevitable crash? Make the most of what is happening in real-time. George Soros is arguably the wealthiest market speculator in the world. When Soros sees a bubble forming, he rushes in to buy adding fuel to the fire. He hasn’t told us how and when he sells. I suppose that is left to the individual speculator and his or her risk profile.
- We all want to know what stage of the bull market we are in. We can then position our trades accordingly. Barton Biggs, a money manager at Morgan Stanley, was known for his global investment strategies. He is credited with identifying Emerging Markets as an asset class. Since what we are witnessing is a worldwide rally in equities, his views on bull markets might help. To paraphrase Barton Biggs, “A bull market is like sex. It feels best just before it ends.”