The Keynesian Beauty Contest and Higher Level Thinking

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03 May The Keynesian Beauty Contest and Higher Level Thinking

Last week I wrote about Howard Marks and his thoughts on Second Level Thinking.

To recap, here are some examples of how First and Second Level Thinking differ

First Level Thinking says – It is a good company, let’s buy the stock. Second Level Thinking says – It is a good company, but everyone thinks it is a good company. The stock is overrated and overpriced, let’s sell the stock.

First Level Thinking says – The outlook calls for low growth and rising inflation. Let’s dump our stocks. Second Level Thinking says – The outlook stinks, but everyone is selling in panic. Buy!

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First Level Thinking says – I think the company’s earnings will fall, sell. Second Level Thinking says – The company’s earnings will fall, but it is already priced in. If it falls less than what people expect, the pleasant surprise will lift the stock. Buy.

First Level Thinking is simplistic and superficial. It is relatively effortless. Thinking in terms of First Levels is both comfortable and comforting.

Second Level Thinking is, in Marks own words, deep, complex and convoluted. It involves asking more questions, examining more possible outcomes, and possibly arriving at radically different conclusions. It is effortful and when carried out correctly, it can be a largely uncomfortable exercise.

Keynesian Beauty Contest

Howard Marks has given us a good framework to base our thinking on. With that in mind, let us examine this rather interesting concept called the Keyensian Beauty Contest.

In his 1936 book, The General Theory of Employment, Interest and Money, economist John Maynard Keynes wrote about a fictional newspaper contest. Out of 100 photographs, participants had to pick 6 faces whom they think is the ‘prettiest’. The person who has gotten the most choices right will be announced winner and will receive a prize.

Now pause for a moment. Imagine yourself to be a participant in this newspaper contest. How would you play this game? Faced with 100 smiling faces, how would you approach the task on hand and select the winner?

Different Levels of Thinking

The naive way would be to select the ones you think is the prettiest. Go down the list and pick your favourites. It is a pleasant exercise and you will probably enjoy doing it. Easy-peasy.

The problem is, beauty is a subjective issue. We cannot measure it with a ruler or a stopwatch. Everybody will have their own preferences and hence, their own definition of beauty. The ones you think are the prettiest may not be the ones that everyone else think is the prettiest.

Case in point, I think Amanda Leong is absolutely smoking hot. My wife disagrees. So does the entire BigFatPurse team.

Amanda Leong

Amanda if you are reading this, I apologies on behalf of the BFP Team. They are unworthy.

Assuming you want to win the contest, the way to approach it would be to exercise Marks’ Second Level Thinking. Instead of picking out the ones you think is the prettiest amongst the 100, pick instead the ones you think all others find pretty.

The process is deep, complex and convoluted. You need to ask more questions (eg, what features does the general public find attractive?) and chances are you might arrive at different conclusions. The pictures you have selected to win might have been somewhat different from the ones you would have personally preferred. It might require me to leave out Amanda in the selection. That in itself will lead to some discomfort.

To take it even one more step further. The participants in the contest will each have their own opinion about other participants’ opinion. They themselves will try to double guess what everyone else is thinking. To win the contest, your role would be to always be one step ahead and successfully double guess everyone’s double guess. It is by no means an easy task.

Keynes sums it up nicely for us

It is not a case of choosing those (faces) that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the forth, fifth and higher degrees.

The Stock Market

In a similar vein, Benjamin Graham had this to say

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

The voting machine tabulates votes from the market players and churns out a price for stocks. It disregards fundamentals. It only cares about what people thinks.

Look no further than how Wall Street plays the earnings game. Companies missed earnings estimates yet see their share price rise. Others exceed estimates only to see prices slump.

Off hand the example of Disney in 2011 comes to mind. In August that year, Disney posted earnings per share of 78 cents, exceeding expectations of 73 cents. Yet, share price slumped by 9% in the days following the announcement.

One can only infer that Disney did not beat expectations by as much as people have expected it to. #oxymornon. To do well in this game, one must be able to infer peoples expectations of the earnings expectations. Higher Level Thinking indeed.

What a crazy game it is 

When Keynes wrote his book 80 years ago, he had the stock market in mind. Eight decades on, even with the current market place bearing little resemblance to the market then, scant little has changed in terms of how human beings approach investment. The parable of the Keynesian Beauty Contest remains highly relevant.

I leave you with one final quote from another prominent economist, the Nobel Prize Winner Robert Shiller. In a NY Times article commenting on the volatility in Wall Street in 2011, he wrote

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.

To participate and to do well in the markets there is no escaping this craziness. Higher Level Thinking is not a bonus. It is a prerequisite. We do not have a choice.

Good Luck Crazy Gamers!

image credit : Amanda instagram, tradesmartonline



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2 Comments
  • General Elections 2015 - Acquiring Worldly Investing Wisdom From Politics
    Posted at 10:58h, 21 September Reply

    […] The psychological process of voting is very similar to picking stocks. We want to pick winners in the stock market and we also want the outcome of the election to reflect our wishes. In order for that to happen, it is not good enough to know how we are to act. We need to figure out how others will think and act, which could be what more than a few voters tried to do. I wrote about higher level thinking here and here. […]

  • How to Invest Better by Knowing Your Investor Type
    Posted at 10:56h, 18 October Reply

    […] which, check out Howard Marks and his thoughts on Second Level Thinking here and here. Taking time to slow down and think deeper will lead to better investment outcomes for the […]

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