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The Washington Independent
Keynesian Beauty Contest: A Trading Strategy For Investors

Keynesian Beauty Contest: A Trading Strategy For Investors

Jun 03, 2021 09:36
finance
Paolo Reyna

Table of Contents

Who is John Maynard Keynes?What is the Keynesian Beauty Contest?How does the Keynesian Beauty Contest work?What does it say about trading?What happens if you randomly pick stocks?

The stock market collapse occurred in October 1987. In the late 1990s, technology stocks grew and fell dramatically. The misplaced exuberance switched to property after the summit in August 2006, triggered by a crash that contributed to the global economic meltdown. Former Federal Reserve President Alan Greenspan even apologized saying that "All of us who have looked after the interests of lending companies in order to defend the equities of shareholders—me in particular—are in a state of shocking disbelief."

Many other economists who fancy the efficient market hypothesis (EMH) were indeed stunned by the recent past, but one man is not shocked: John Maynard Keynes.

Who is John Maynard Keynes?

Keynes is recalled for his opinion that governments can invest resources to recover maximum jobs during recessions, which was famously argued by the General Employment Theory, Interest and Money (1936). However, few people realize that he was a real precursor to behavioral finance. If more people had researched the Chapter of the General Theory of Financial Markets, like Greenspan, the recession may have been stopped.

At the start of the twentieth century, Keynes considered markets to be more "effective," where management held much of the business shares and understood what they were worth. When the securities are more broadly spread, "those who buy or intend to own them have seriously reduced the factor of actual information in the value of investments."

Keynes was often skeptical of the part played by experienced fund managers as the "smart money" that EMH advocates depend on to maintain market efficiency. Instead, he felt that they should navigate an irrational wave of exuberance rather than combat it. One factor is that it's dangerous to be an opponent. "World knowledge teaches that the prestige of traditional failure is greater than unorthodox success."

What is the Keynesian Beauty Contest?

Keynes felt experienced fund managers played a complex game. He likened it to a regular newspaper game in which competitors have to choose from 100 photos of six beautiful faces that give awards to the competitor, whose choice corresponds more to the average preference of contestants as a whole: so any competitor must choose not those faces which he himself finds most beautiful, but those which he thinks the most likely to catch the competition. We also hit the third stage where we focus on predicting what the average opinion expects to be. And others, I think, practice the fourth, fifth, and higher grades.

How does the Keynesian Beauty Contest work?

The beauty competition example of Keynes remains a fitting explanation of how stock markets function and of the important position of behavioral variables. This is the analogy of the said beauty contest:

Pick a number from zero to 100 in order to get your guess as equal to two-thirds of the average guess of the contestants as practicable. To help you think about the game, assume three players guessed 20, 30, and 40. The average guess is 30, of which 2/3 is 20, so the one who conjectured 20 will draw.

You might wonder what the conjecture would have been if you didn't join the competition.

Now that you've been thinking, imagine what I'm going to term a zero-level thinker. He says, "I don't know, I don't know. This sounds like a challenge for mathematics. I'm just going to choose a random number." Many individuals estimating a number randomly between zero and 100 would yield an average estimate of 50 percent.

How about a thinker at the first level? The player would say: "The other players don't really want to think much, so maybe they'll take a random number, averaging 50, I suppose 33, two-thirds of 50."

A second-level thinker is saying: "Most players are thinkers of the first level and assume some players are a little weak, so they estimate 33. But I'm going to say 22."

A thinker on the third level: "Many players would understand how the game functions and to think most others would guess 33. They guess 22, but I'm going to guess 15."

The cycle goes on until levels 4, 5, 6, 7, 8, and so on.

What does it say about trading?

The beauty pageant comparison of Keynes remains a suitable explanation of what financial advisors are doing. Many buyers name themselves "value managers," which means they try to purchase inexpensive stocks. Others label themselves "growth managers," which means that they aim to purchase stocks that rise fast. But of course, nobody is trying to purchase stocks that are costly or stocks of firms that are going to shrink. But what the managers are really aiming to achieve is to purchase securities that increase value—or, in other terms, stocks that they believe will be valued more later by other buyers.

It's all right to buy a stock that the consumer today doesn't completely understand, as long as the majority of the market comes to mind earlier rather than later. Recall another of Keynes' iconic lines: "We're all dead in the long run." A fund manager usually only lasts for a few years; sometimes only a few months! A fund manager would also have a hypothesis of how other people shift their minds to beat the business. In other terms, it would be a behavioral solution.

What does it say about trading

What happens if you randomly pick stocks?

Stock picking randomly is sometimes more efficient than having extensive research or knowledge about a given stock.

If you have taken an elementary finance course at college or university, you will remember the effective theory of the economy (EMH).

This theory means that market players are sophisticated, educated, and act only on the knowledge accessible. Since all have the same access to this knowledge, all shares are adequately valued at any given moment.

While this hypothesis would not actually contradict the principle of stock picking, the validity of the consistent opportunity to outperform the competition by leveraging knowledge that cannot be entirely mirrored in the price of protection is questioned.

For instance, if a portfolio manager buys a safe, he believes it is valued more than the price charged now and in the future. The Fund Manager may often be required to offer a security for a small sum of capital that they think is less valuable today or in the future, again including the use of knowledge that hasn't been expressed in the market price.

The EMH usually occurs in three different forms: weak, semi-strong, and strong. The weak theory states that current prices precisely depend on historical prices; semi-strong suggests that current prices correctly represent financial details for investors; and strongly shaped prices are the most stable type, which means that all knowledge essentially has been incorporated in the security price.

If you adopt the first method, you are more certain that technological research is not useful or useless; the second form means you can discard the basic safety assessment techniques; you may even hold your cash under your mattress if you adhere to the solid form.

Paolo Reyna | Paolo is a senior at the University of Illinois at Urbana-Champaign, majoring in International Studies with a Latin American emphasis. During the fall semester of 2012, he had the opportunity to study abroad in Peru, which piqued his interest in international growth. He learned about the disparities that impact indigenous peoples, got a taste of Peruvian culture, and improved his Spanish skills. Mitchel interned with the Chicago Council on Global Affairs, conducting research on food security in Latin America, after being inspired by his foreign experience. He wants to work in international development and for a government department, writing legislation. He loves playing intramural basketball and practicing for the Chicago marathon when he is not thinking about current events in Latin America.

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