Shiller: Keynes' Beauty Contest Problem

Robert Shiller:

The Beauty Contest That’s Shaking Wall St., by Robert Shiller, Commentary, NY Times: The extraordinary surge of stock market volatility during the last month ... has been linked to news events. Much of it came after S& P ... downgraded the nation’s long-term debt... It’s tempting to think that the market has been responding rationally to these developments. But that isn’t an adequate answer. Why did investors react so strongly to the rating change, which, after all, was merely the opinion of a few analysts on a committee? And why did the market swing so much day to day, even when there was no significant news? ...

Keynes supplied the answer in 1936 ... by comparing the stock market to a beauty contest. He described a newspaper contest in which 100 photographs of faces were displayed. ... The winner would be the reader whose list of six came closest to the most popular of the combined lists of all readers.

The best strategy, Keynes noted, isn’t to pick the faces that are your personal favorites. It is to select those that you think others will think prettiest. ... Similarly in speculative markets, he said, you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher. ...

The ... best explanation for the market’s back-and-forth swings is that each day we are conducting a Keynesian beauty contest, and reassessing what others think that still others are thinking. On days without much news, the market is simply reacting to itself. And because anxiety is running high, investors make quick, sometimes impulsive, responses to relatively minor events. ...

This may sound like a crazy game, but if others are playing it, we must, too. The outlook for the economy depends on how this convoluted beauty contest plays out.