The Hindu Business Line : <I>Markets and beauty contests </I>

Keynes, the British economist, is often quoted for comparing financial markets to a beauty contest. The beauty contest ran like this: An English newspaper would publish 100 photographs. The participants had to guess what others were guessing was the most beautiful face. Keynes' comparison seems relevant even today. We can use the beauty contest to define three classes of people in the market — fundamental players, technical traders and speculators.

Observe the nature of the beauty contest. It is not who you think is beautiful. You win only if your pick matches that of others. So, you had to guess what other people were guessing. And other people were doing the same thing. So, the contest was essentially about which face most people thought was beautiful! Confusing?

If you buy only on fundamentals, you pick a beautiful face without bothering about what others are thinking. You "know" that other people will eventually come to realise that the face you picked is indeed the most beautiful. So, they will also pick that face.

What about technical traders — those who use charts — to buy/sell stocks? The price charts are footprints of human behaviour. If your entire neighbourhood buys a stock and the price moves up, the technical trader may buy the stock as well as depend on the chart pattern.

In terms of the beauty contest, the speculators are those who pick a girl they think is beautiful and wish others would also do the same! Which group do you belong to?

(The author is based in Toronto, Canada.)

More Stories on : Stock Markets | Simple Economics

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page