Playing the Keynesian beauty contest game on the NSE

Most models of economic behaviour are based on the assumption of rationality of economic agents and common knowledge of rationality. This means that an agent selects a strategy that maximizes his utility believing that all others do the same (are equally rational) and that all agents believe that all others believe that all agents are rational.

The Keynesian beauty contest is the view that much of investment is driven by expectations about what other investors think, rather than expectations about the fundamental profitability of a particular investment. In 1936, John Maynard Keynes, in “The General Theory of Employment, Interest and Money”, likened the stock market to a beauty contest.

He described a newspaper contest in which 100 photographs of faces were displayed. Readers were asked to choose the six prettiest. The winner would be the reader whose list of six came closest to the most popular of the combined lists of all readers.

The best strategy, Keynes noted, isn’t to pick the faces that are your personal favourites. It is to select those that you think others will think prettiest. Better yet, he said, move to the “third degree” and pick the faces you think that others think that still others think are prettiest.

Similarly in speculative markets, he said, you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher.

A naive strategy for an entrant would be to rely on his or her own concepts of beauty to establish rankings. Each contest entrant would try to second-guess the other entrants’ reactions, and then sophisticated entrants would attempt to second-guess the other entrants’ second guessing.

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Each potential entrant (investor) now ignores fundamental value (i.e., expected profitability based on expected revenues and costs), but instead tries to predict “what the market will do”. The results are that investment is extremely volatile because fundamental value becomes irrelevant, and the most successful investors are the masters at understanding mob psychology – strategic game playing.

It’s tempting to think that the Nigerian equity market has been responding rationally to recent global developments, particularly the outlook for Nigeria’s external competitiveness. But that isn’t an adequate answer.

In part, the exchange rate volatility, and eventual devaluation of the naira was engendered by foreign participants in Nigeria’s financial markets. And their strong reaction was to protect their capital gains. It is a reaction to the fear that other foreign speculators will exit the market, pushing prices of financial instruments down, and NGN/USD exchange rate up.

Once this contagion began, it was an arduous, if not impossible, task to call the end of the spiral. This has left the domestic investors trying to guess whether other investors are thinking that yet others are thinking that the stock market is “dangerous”, or whether it is instead a great time to invest.

If the majority of investors were trading by calculating an optimal portfolio based on a rational statistical analysis of fundamental economic data, then the market swings will be much more minimal. Based on observation of common market behaviour, it is safe to conclude that very few investors are doing those calculations today. If investors were believers in efficient markets, then this will reflect in their investment decisions, and market volatility.

In fact, the best explanation for the market’s back-and-forth swings is that each day we are conducting a Keynesian beauty contest, and reassessing what others think that still others are thinking. On days without much news, the market is simply reacting to itself. And because anxiety is running high, investors make quick, sometimes impulsive, responses to relatively minor events.

This process creates uncertainty not only for the stock market, but also for the overall economy. We are constantly trying to reassess the fear of others, and others’ fear that others are also afraid. Thankfully, there are scientific methods that capture these different anomalies engendered by investors’ behaviour influenced by this beauty contest game.

The outlook for the market depends on how this convoluted beauty contest plays out. This may sound like a crazy game, but if others are playing it, it is in our best interest to understand and play it too.

 

Olugbenga A. Olufeagba

Senior Consultant, Markets Practice, Kainos Edge Consulting Limited.