Keynesian Beauty Contests
Keynes’s beauty-contest metaphor describes investors trying to anticipate what other investors will buy. In speculative markets, expectations about others’ expectations can influence prices alongside judgments about an asset’s underlying value.
THE IDEA
Keynesian Beauty Contests
When people speculate—meaning they purchase an asset intending to resell it later at a higher price—they engage in a Keynesian beauty contest. This involves assessing the price of something based on ever more elaborate estimations of other people’s estimations of its value. Economist John Maynard Keynes used the metaphor of a beauty contest to explain how stock prices are set.[7] He asked readers to imagine a contest where entrants must choose six faces out of a hundred; those who pick the faces chosen by the most other people win.
Keynes believed stocks are priced not according to their intrinsic value but according to investors’ perceptions of other investors’ perceptions of their value. Even when investors have access to similar public information, they may interpret it differently. A speculator therefore considers how others might react, as well as what the asset appears to be worth. First-order thinking is not enough. Second-order thinking—the act of thinking of the consequences of consequences—is necessary for useful predictions. (For more on second-order thinking, see volume 1 of The Great Mental Models.) Thinking through further levels can expose assumptions about other participants, but does not guarantee a more accurate prediction.
The Keynesian beauty contest contradicts the idea of markets as rational, with stocks priced per their intrinsic value. Consequently, it provides a means of understanding irrational behavior, like that which creates economic bubbles. If prices are rising fast, investors may think other investors will think they will keep rising and therefore may keep buying. This leads to out-of-control pricing. The same dynamic can arise in other asset markets when buyers expect to resell to someone willing to pay more.
When to use it
Stock market investing: When evaluating a hot IPO, recognizing that its price may be driven by expectations of others' enthusiasm rather than company fundamentals.
Cryptocurrency trading: Many participants buy based on the belief that others will buy later, creating speculative bubbles.
Housing market: During a real estate boom, buyers might purchase not because houses are undervalued but because they expect prices to keep rising as others jump in.
FROM THEORY TO EVERYDAY LIFE
In practice
Stock Market Bubbles
When prices are rising fast, investors buy not because they think the asset is undervalued, but because they think other investors will think prices will keep rising, leading to further buying and out-of-control pricing.
Beauty Contest Metaphor
In a contest where entrants choose six faces from a hundred, winners are those who pick the faces most chosen by others. Investors similarly try to pick stocks that others will find desirable, not necessarily those with the best fundamentals.
A MOMENT TO REFLECT
Put it to work.
In what situations are you prone to engaging in Keynesian beauty contest thinking, focusing on others' perceptions rather than intrinsic value?
How can you distinguish between an investment based on fundamentals and one based on second-order speculation about others' behavior?
When was the last time you observed a bubble forming? How did the beauty contest dynamic play out?
References
- The General Theory of Employment, Interest and Money — John Maynard Keynes (1936)
CONTINUE THE CONVERSATION
Source texts
- The Great Mental Models Volume 4 Economics and Art