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Keynesian beauty contest:
[T]here is an interesting theory about human decision making behaviour. Name of the theory is “Beauty Contest Theory” which was developed by John Maynard Keynes, an Famous Economist of 1930s.
In his famous work ‘General Theory of Employment, Money and Interest’, he explained the “Beauty Contest Theory”.
Suppose that there is a contest to select 6 most beautiful faces from the photographs of 100 faces of women. You will be given a prize if the 6 most beautiful faces selected by you are also selected by the majority of other contestants. What faces will you select?
Obviously, the 6 faces you think that are most beautiful. But remember, you will win the prize only when the 6 faces chosen by are also chosen by the majority of other contestants. What will you do? You will start thinking about how all the other contestants would think and select. Then you will start selecting the faces which you believe that most of the other contestants will also select.
Similarly, all the contestants think in this manner and choose the faces which are not the faces that they think as most beautiful but the faces which all the other contestants would think as beautiful. Take this to the next level.
You know that all the other contestants are behaving in the same manner. So you now start thinking about what all the contestants would think as all the other contestants think and then decide the most beautiful faces. This can be to the next level also.
In the words of 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 practice the fourth, fifth and higher degrees.”
Effect of beauty contest theory in stock market
The quote from Keynes describes a market in which investors care about what other investors will buy in the future. Here, you often pay more than a firm is worth, because you think that somebody else will pay even more later on.
If a stock price has to rise – there should be enough people who are willing to pay a high price for it. Or at least a price higher than what you paid.
With that in mind, you can buy two types of stocks:
- Ones that you think are the prettiest (fairly valued or great companies etc.)
- Ones that you think others will find prettiest.
Keynes believed that most people in the stock market were busy finding the face, which others would find prettiest, and ignored the one that they themselves found pretty. This is why a lot of people talk about hot tips and other such things that imply that there is popular interest in a particular stock and buyers will drive its price higher.
This strategy is sometimes called the “greater-fool theory,”because even though you’re a fool to pay as much as you did, you’re betting that there’s a greater fool just down the road. And if you’re right, then of course you aren’t being foolish.
Sometimes prices rise because people expect them to rise
The greater fool theory is similar to the Keynesian beauty contest, but is probably abstracted to one more level. The Greater Fool theory describes a situation like this:
I see a house in a dilapidated neighborhood, and the asking price for that house is half a million dollars. I know that the house is not worth that much, and I’d be a fool to buy it. However, if I can find a greater fool – who is willing to buy that house for more than half a million dollars, the deal won’t be so bad after all.
When you buy an asset in the hope that some one else will buy it for more than that from you, and not because you believe that it is worth that much to you – Keynes’ Beauty Contest and the Greater Fool Theory work perfectly here.