In the 1930’s, a popular newspaper game had people guess the prettiest face out of 100 photographs. Readers selected six faces each, and their choices would be compared to all other players’ submissions. If a player’s choices included the most popular face in the pool, they would win a prize.
One morning, famed British economist John Meynard Keynes read about this game in his local newspaper. Up until this point, Keynes, while a brilliant macroeconomist, struggled immensely in the stock market. He would try to predict when financial markets would change based on macroeconomic policies he expected to change; but despite knowing more about economics than most of Britain, he still only managed to collect average returns.
Due to his failure to reliably predict the market, Keynes was beginning to wonder if doing so was even possible. He, therefore, became interested in finding a model that explained what created rapid stock market bubbles, crashes, and other rapid price fluctuations, despite fundamental value not changing much from the day-to-day. The beauty contest game caught his eye as a potential model, and he proceeded to write about it in his 1936 work The General Theory of Employment, Interest and Money.
According to Keynes, you can use multiple different strategies when playing the beauty contest game. First, you could simply pick the six faces that you personally find most attractive. Keynes and other economists call this a “naive strategy,” as it is based on the assumption that your preferences are universal. Another strategy involves basing your decision on what you believe other players will find attractive. This is slightly more rational, however, it operates under the assumption that everybody else is using the naive strategy.
But what if everybody else used this more sophisticated strategy, and tried to guess what others find attractive? Well, then it gets complicated. You not only have to guess what other people find attractive; you also have to guess other people’s guesses, too. But once we’ve adopted this strategy, we end up in an infinite loop. To get ahead, each player needs to go one level deeper than everybody else: they need to guess other people’s preferences, and other people’s guesses, and other people’s guesses about other people’s guesses; and so on. While there could be an eventual winner, a simple game of deciding which faces are more beautiful becomes an intricate, infinite guessing game.
Keynes likened this form of strategic thinking to the stock market. To make quick money speculating in the stock market, you must buy before everybody else buys and sell before everybody else sells. By doing this, you can ride waves of investor confidence and get out before it inevitably tumbles. Therefore, if you can find out what the majority of players in the stock market were thinking, you can beat them. However, Keynes warns, we typically try to do this using the same flawed, infinite reasoning that we see in the beauty contest. We try to guess what other investors will buy and sell, and what other investors will guess about other investors, and what other investors will guess about other investors; and so on, forever. While it is possible to win big if you guess everything correctly, you are much more likely to lose. Guessing an infinite number of times all but guarantees that you’ll guess wrong at least once.