Keynesian Beauty Contest is a well known concept that Keynes has used to described the valuation of stocks. We know that a piece of stock should represent a portion of value of the underlying business. But why do stock prices vary so much from the fundamental value at times? Keynes quoted the example of a beauty contest, which was ran by a newspaper and was popular in England for a period of time. The following paragraph is quoted from “General Theory of Employment, Interest and Money“,
“…professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”
As the stock market attracted more participation, stock prices are influenced by the aggregated perception from the investors. In fact, the perception is becoming very, very influetial. Hence, it is then not sufficient to choose the “prettiest face” (best value stock) based on your judgement, but to anticipate what the majority is choosing. In other words, people are second guessing other people. The majority is scrutinising the biggest gainer and top volume stocks, looking for the next hot stock.
How can this understanding help you to invest, using the technical or fundamental approach?
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Technical Analysis – Traders want to trade stocks that move. Volume becomes one of the important factor to consider. The key would be to devise a system to help interpret this aggregate perception and prompt the trader to get in early with the crowd, but most importantly, leave before the music stops.
Fundamental Analysis – Unlike traders, fundamental investors look for value stocks. The only way to buy a value stock is to wait for the aggregated perception of investors to be bearish such that it will influence the stock price to go below the fundamental value. At this point, the demand and volume of the stock will be low. Getting in is just one side of the story, value investors have to wait for the aggregate perception of the stock to rise so that the price can be pushed up. And this can take a long period of time or may not happen at all.
As you can see, the key is not about using which approach, but the ability to discern the aggregated perception of investors that is the most crucial.