Keynesian Beauty Contest and The Greater Fool Theory

by Manshu on March 4, 2009

in Articles

Keynes wrote about an imaginary beauty contest, as a way to explain the way people behave in the stock markets.

The contest will be won on popular vote, and people will vote in with their favorite choice.

On top of the winning contestant, there is a voter’s prize as well. If you vote for the winning contestant – you will then be eligible for a prize yourself. If you vote for a losing contestant, then you don’t stand a chance of winning anything.

If I am a voter in such a contest, I can do one of the two things:

  1. I can vote for the prettiest contestant or
  2. I can vote for that contestant who I think others will find most attractive. This will increase my chances for winning the voter’s prize.

The second point above is like seeing a contestant on American Idol and saying:  “I don’t like this guy, but I know that people are going to vote for him and he will win”.

Most people who want to win the voter’s prize are likely to think in the second way.

Which is the Prettiest Stock?

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:

  1. Ones that you think are the prettiest (fairly valued or great companies etc.)
  2. 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.

The Greater Fool Theory

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 – think about Keynes’ Beauty Contest and the Greater Fool Theory.

Then think about the current recession and where such thinking will lead you to.

{ 2 comments… read them below or add one }

Dana March 4, 2009 at 8:05 am

This is the perfect analogy to the asset bubble that raged and ravaged western financial institutions and investors. The idea of popularity was so prevalent and central to the continuous rise in assets, mainly property prices. Everyone knew the prices were outrageous, but as long as nobody said anything, all was well. Then one day, someone snapped out of the trance, and realized the emperor had no clothes.

Have you seen the Vanity Fair report on the fall of Iceland? It’s slightly cruel and snarky, but like those supermarket checkout gossip rags, so fascinating and juicy, I couldn’t stop reading.

http://www.vanityfair.com/politics/features/2009/04/iceland200904?printable=true&currentPage=all

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Manshu March 4, 2009 at 9:21 am

Dana – Thanks for posting the link. It was a great read. My favorite line was not so much from the article, but the intro to it.

“In Reykjavík, where men are men, and the women seem to have completely given up on them, the author follows the peculiarly Icelandic logic behind the meltdown.”

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