Imagine a beauty contest.
You’re one of many judges. But instead of the models, it’s the judges who get a prize.
To win you don’t have to pick the model you believe to be the prettiest. Instead you have to pick the model you think most of the other judges think is the prettiest.
How would that inform your pick?
Maybe you might avoid picking the model you like the most. You probably wouldn’t even pick what you think to be the average opinion of the prettiest. You’d likely go down a rabbit hole of trying to predict what others are predicting the average to be.
Economist and investor, John Maynard Keynes, wrote about such a contest in his book, The General Theory of Employment, Interest and Money.
‘It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that 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 practice the fourth, fifth and higher degrees.’
The point of the exercise is to show how ridiculous the thinking is of some stock investors. I’m sure you know the ones. Investors who believe they can outsmart the market.
They jump in and out of stocks just before the herd, making multiple times their money in the process.
I’m not just describing the technical or momentum trader here. Value investors also fall into this camp. Instead of buying stock they believe to be cheap. They buy stocks they believe the market will believe are cheap.
For most, this kind of strategy turns out exactly how you’d think. It wastes a whole lot of time and money.
Don’t be a Homer Simpson investor
Even ‘expert’ fund managers try their hand at picking stocks the market likes. To them, it’s the ‘stupid individual investors’ who pile in after them. But more than often they’re punished for trying to be brilliant.
In James Montier’s book, The Little Book of Behavioural Investing, he decided to replicate Keynes’ beauty contest.
He asks fund managers to pick a number from 0–100. The goal is to pick the number closest to two thirds of the average. Meaning if the average number was 50, the best number to choose would be 33.
How did the experts do?
Would you believe it, someone picked 100…
Source: The Little Book of Behavioural Investing
[Click to enlarge]
‘The highest possible correct answer is 67. To go for 67 you have to believe that every other muppet in the known universe has just gone for 100. The fact that we got a whole raft of responses above 67 is more than slightly alarming.
‘…you can see spikes that represent various levels of thinking. The spike at 50 reflects what we (somewhat rudely) call level zero thinkers. They are the investment equivalent of Homer Simpson, 0, 100, duh 50. Not a vast amount of cognitive effort expended here!
‘There is a spike at 33 from those who expect everyone else in the world to be Homer. There’s a spike at 22, again those who obviously think everyone else is at 33.
‘As you can see there is also a spike at zero. Here we find the economists, game theorists, and mathematicians of the world — clearly they have no friends.’
As it happens, the average number from 1,000 players was 26. That means those who picked 17, two thirds of the average, won.
But how many landed on 17? Just 0.3% (three people). And how did they come to the number 17? Your guess is as good as mine.
Don’t be brilliant, be rational
I suspect if you ran the experiment again, you’d likely get a different correct number from another round of money managing ‘experts’.
Again, the idea here is to demonstrate how hard it is to outsmart the market. Trying to pick the stock the market likes, or the stock everyone is about to buy, is a loser’s game.
A far better alternative is to buy stocks of companies you understand, for a price less than you think the business is worth.
To quote Charlie Munger, ‘A lot of people are trying to be brilliant. We’re just trying to be rational.’
Editor, Money Morning