Six Pretty Faces

It’s the mid-20th century, and you’re living in England. You open up your Times newspaper to catch up on the news of the world, and you see a full-page advertisement for a contest of sorts.

There are six pretty faces in six little squares, and at first glance, you reckon the contest is to determine who’s the most beautiful among them. Instead, the goal is to pick the face that the most people will choose as the most beautiful.

You’ve got until tomorrow’s post arrives to make your decision, and then you can mail your answer in to the company running the contest. If you win, you get a share of the cash everyone puts in, and if you choose wrong, you just lose your “investment” altogether.

What happens when you try to decide which face will win?

Sure, you could choose the face you personally think is most attractive, but you know that your tastes in beauty can be somewhat eclectic, so you’d probably want to pick someone else. Who would the largest number of people choose to be the prettiest face?

Well, then, that’s pretty easy to solve! You can just pick the face that most folks would find attractive, and vote for that one. That’s the clear winner.

Or is it?

Not so fast! Other people know exactly what you know, so they’re going to be thinking the same things. You need to level up your thinking here, and figure out what the average beautiful face is. You need to pick the face the most people will pick, knowing that everyone is trying to figure out which pretty face everyone will pick.

Here you are, thinking about thinking about thinking.

Of course, now that you know most smart Times readers will likely draw the exact same conclusion, you zoom up another level. Clearly, nobody will pick the face you think is prettiest, nor will they pick the face the most people think is prettiest. Instead, they’re likely to choose one of the more unconventionally pretty ones.

And so on, up the ladder your brain can go, almost indefinitely.

This is called a Keynesian beauty contest.

Yes, that Keynes—John Maynard, to be precise. I’ve written about his ideas and his fascinating life before, and I’ll do it again. Keynes wrote about his beauty contest idea in The General Theory of Employment, Interest and Money, published in 1936.

This was a direct analogy for financial markets, showing how speculation and expectations drove short-term prices, not just business fundamentals. It’s pretty easy to apply the contest analogy to stock-picking, especially since stocks really are, as Ben Graham put it, voting machines in the short term.

Popularity contests and short-term stock-picking aren’t really all that different, at least insofar as they both require additional levels of thinking. The more people who buy an asset like a stock (or crypto, if you want a decent 21st century example), the higher the price goes as additional investors bid the price up.

If a stock (or cryptocurrency, or whatever) is going up in price, you might conclude that you should buy it quickly and take advantage of that momentum… unless, that is, you determine that other investors have lost patience with the recent rally.

If those investors get sick of this one asset (stock, crypto, art, whatever), then what would they buy instead? Go buy that now, so you can sell it to them later when the price is driven up (or so the conventional wisdom goes).

This sort of psychology goes far to explain market bubbles and manias, and Keynes was great at encapsulating this idea. The more people who are aware of the potential for a bubble to form, the more likely they are to avoid one in the first place.

This sort of thinking ladder isn’t just useful in the stock market! It can also come in really handy during a battle of wits concerning iocane powder:

As Yogi Berra put it, “It is difficult to make predictions, especially about the future."

Even understanding all of this logic and knowing that humans can be irrational isn’t enough to solve the problem, since everyone else has the ability to understand these principles.

Back to our pretty faces: we humans are endlessly trying to figure out what other people think. Determining how people will behave can be every bit as important as figuring out the most logical solution to a problem—these are not always the same! Even further, trying to get this right can be incredibly difficult for the greatest minds on the planet.

Props to Keynes for pointing this out so eloquently.