The idiosyncrasies that keep us poor

Renowned British economist John Maynard Keynes introduced the idea of the ‘Beauty Contest’game likening it to investing in the stock market. Here are the rules of the ‘beauty contest’ game.

 People are shown photographs of 100 people and are asked to choose 6 photographs from the lot. The winner is the person whose selection of photos is the most popular across all contestants. In the words of Keynes himself, “prize is awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors.”

So the task, in the minds of the competitors, is not one of choosing the prettiest people. It is not even one of choosing the photos of those faces that other people may find pretty. But it is one of choosing those photos that other people think will be the most popular – This is third-degree anticipation.

A lot of stock market investors have reduced the problem of investing to precisely this – Instead of spending their time and energy in finding good businesses, they devote intelligence in unearthing stocks that other people may think are good investment ideas. In some cases, this may work! If we’d picked up Gamestop before the massive rally, we would have made a lot of money. The downside though is that such investors lack the conviction to hold these stocks for the long term – which is when money is really made.

Setting that aside, can we really anticipate the average public opinion about stocks? Is this even possible?

Consider a variant of the game played in lab experiments. Say, 100 people are invited to a lab and asked to choose a number between 0 and 100. The winner is the person whose selection is closest to one-half of the average of all numbers submitted. Now, I am sure you figured it out that there is no point submitting a number over 50. And you’d be quite right – if everybody chose 100, the average would be 100 and the winning number would be 50 (one-half of 100).

 Now, what if other people are just as intelligent as you are? They will all end up choosing 50. If that happens, then the average of all choices will be 50 and the winning number will be 25 (one-half of 50).

 Now, what if everybody realised this and chose 25? The winning number will be 12.5! You see where I am going with this…

 If you recursively moved down, you will realise that the correct answer to this problem is for everyone to choose 0. The average pick will be 0 and one half of 0, the winning number, is also 0.

 In an empirical study with a setting just like this, you’d expect that people will all choose 0. The answer however is far from it! In a lab study, the average pick was 40! And what does that prove? – that there are limitations to rational thinking. The average public opinion does not always have to be rational. And therein lies the problem of trying to anticipate what popular opinion is about a stock. It may not be rational. In the long term, the market does not reward irrationality. It rewards good businesses.

 So, stop reading this, and go pick some good businesses to invest in 🙂

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