Keynes famously used the analogy of a beauty contest to explain why stock prices can differ from their fundamental value. He describes the actions of rational agents in a market using an analogy based on a fictional newspaper contest, in which entrants are asked to choose the six prettiest women from a hundred photographs. Those who picked the most popular face are then eligible for a prize. A naive strategy would be to choose the face that, in the opinion of the entrant, is the most beautiful. A more sophisticated contest entrant, wishing to maximize the chances of winning a prize, would think about what the majority perception of beauty is, and then make a prediction based on some knowledge of the public’s perceptions.3
Keynes believed that similar behavior was at work in the stock market, i.e., that investors often ignore underlying conditions, and instead try to extrapolate short-term market psychology as a way to derive investment returns. It is likely Keynes would see this mindset reflected in current investment behavior where the focus is often on short-term trading activity in reaction to market noise, i.e., what other market participants are thinking, rather than investment decisions based on the fundamental longer-term value of an enterprise.
With demographic trends pointing to a greater focus on longevity risk and more attention being placed on the downside of short-term investment behavior by governments, regulators and even the financial media, the tide may turn in the coming years. Regardless, we believe an arbitrage opportunity exists for managers with a longer investment horizon: There are more opportunities for differentiated performance when one holds securities for longer time periods.
1 Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, 2nd ed., (New York: Thompson Texere, 2004), 61.
2 BIS website (10/15/2013) https://www.bis.org/publ/joint31.htm
3 John Maynard Keynes, The General Theory of Employment, Interest and Money (1936), Chapter 12.
A version of this paper was first published in November 2013.
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