What is the Keynesian Beauty Contest?
The Keynesian beauty contest is a concept from behavioral finance where participants gain by predicting the majority's choice rather than making personal judgments. Applied to stock markets, it suggests that investors profit more by anticipating popular stocks, rather than those with intrinsic value, leading to irrational price fluctuations.
The Basic Idea
How do you define beauty? You probably have a bevy of individual preferences. If asked, you could likely even give reasons about why you find certain things beautiful. However, if you have ever shared your opinions with other people, you might have realized that your standards of beauty are not universal: one person’s “beautiful” is another person’s “ugly.” Oftentimes, this diversity of preference is a good thing. In the dating world, our diversity of preferences enables everyone to find a partner– it would be pretty difficult if we were all vying for the same few people. But while our varied individual preferences may be useful in finding us a date, they are fueled by an irrational logic that can cause problems elsewhere.
The Keynesian Beauty Contest is an early theory in behavioral finance that describes how our perceptions of value can cause irrational fluctuations in supposedly rational systems. More specifically, it describes how short-term stock market fluctuations are not caused by changes in underlying value, but instead by investors attempting to figure out what others think the “average investor” finds valuable. According to this theory, attempting to time market changes is like trying to guess what your friend’s next partner will look like–you make guesses based on what you think they find “beautiful.” And in the same way we often fail to correctly guess our friends’ preferences, the Keynesian Beauty Contest shows that when we try to predict what others find valuable, we often get it wrong.
Successful investing is anticipating the anticipations of others.
– John Meynard Keynes, British Economist
