The Keynesian Beauty Contest is a concept developed by John Maynard Keynes and introduced in Chapter 12 of his work, The General Theory of Employment, Interest and Money (1936), to explain price fluctuations in the stock market.
How It Works
Keynes described the behavior of rational stock market investors, using an analogy based on a fictional newspaper contest. This came to be known as the Keynesian Beauty Contest. The newspaper showed the pictures of 100 women, and entrants were asked to choose a set of six photographs of the women that are the "most beautiful." Those whose set of six selections included the most popular face would then be entered in a raffle to win a prize.
A naive strategy would be to choose the face that, in the opinion of the entrant, is the most beautiful. But a more sophisticated contest entrant, wishing to maximize the chances of winning a prize, would think about what the majority perception of beauty is, and then make a selection based on some inference from his knowledge of public perceptions.
The Keynesian Beauty Contest strategy can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus, the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational participants.
Keynes believed that similar behavior was at work within the stock market. This would have people pricing shares not based on what they think their fundamental value is, but rather on what they think everyone else thinks their value is, or what everybody else would predict the average assessment of value to be.
Today's Keynesian Beauty Contest
Keynes was referring to professional investors in the early 1900. But the concept he was describing is as valid today as it was nearly 100 years ago. In fact, it may be even more prevalent today. In Keynes' time, the market was dominated by individual investors, most of whom were simply speculating with their stock picks. Today's market is dominated by professionals, and very large and concentrated pools of money.
Thanks to the explosion of technology, there's a wealth of investing information just a click away, and investors should assume that everything they know about a stock is also known by everyone else. Therefore, the information edge that existed in Keynes' day has mostly disappeared. The edge for investors today, if there is one, is in the ability to anticipate what other investors think the price of a stock should be.
Stated differently, we're no longer trying to pick what we think are the best stocks to buy, based on our own assessment of fair value. That's the quaint notion of 1st order thinking. We're not even trying to pick the stocks that we think everyone else likes. That would be 2nd order thinking. Today, we're picking the stocks that we think everyone else thinks are the stocks that everyone else likes. This is 3rd order thinking, and it's just what Keynes was describing with his beauty contest analogy.
This concept forms the basis of observable phenomena in today's stock market. Concepts like price momentum, herding behavior, and asset bubbles. These are things that should not exist in a vast, open market with rational participants. But they do exist, and will continue to exist as long as investors seek to "beat the market" by outsmarting the crowd. Personally, I hope that these noise traders stick around for another 100 years because they are the ones who create mispricing in the market. Understanding how to recognize that mispricing, and take advantage of the opportunities that it creates, is what separates the winners from the losers in the Keynesian Beauty Contest.