How good are you at out-guessing your opponents?
I like to keep up to date with what's going on in the world, so I was intrigued to read in that most learned and erudite of publications, the Daily Mash, that "the number of people with something to say about house prices rose by 15% in July, according to a report by the Institute of Chartered House Price Opinion Surveyors".
And while that's just a bit of fun, like all good satire it contains a grain of truth, in this case a truth about the game-playing that goes on in the various markets. For many of us, the intrinsic value of a company (or property) is less important than the consensus opinion of the other market players.
And that's a particularly difficult game to play, arguably more difficult than putting an actual value on a business. It involves not just guessing what the other players believe to be the right value, but guessing what they think everyone else thinks is the right value. The belief that we can do this, and stay one step ahead of everyone else, is one of the drivers of market bubbles.
Keynes' beauty competition
JM Keynes, in his General Theory of Employment, Interest, and Money, likened the markets to a newspaper beauty competition, in which the winning entry would be drawn from amongst those who chose the picture that was most popular.
"... each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which 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 practise the fourth, fifth and higher degrees."
Montier's experiment
Since the mid-1990s a version of this game has been played in which players are asked to pick a number between zero and 100, where the winner will be the player who picks a number closest to two-thirds of the average number picked. It need not be a whole number.
One of the most famous instances of this game was in early 2004, when James Montier (who will be featured in our Investment Greats series in the coming weeks) polled investment professionals and received 1,002 replies.
Surprisingly, 5% of the respondents chose a number greater than 67, which is clearly a losing strategy -- even if every other player chose the maximum value of 100, two-thirds of this would be 67, so a higher number is not going to win. Either they didn't grasp the fundamentals of the game, or they are somewhat challenged in the rationality department. And remember, we're dealing with investment professionals here.
What Montier describes as 'level zero' players chose 50, the mean from a random draw. 'Level 1' players chose two-thirds of 50, i.e. 33. 'Level 2' players assumed that everyone else would pick 33, so they chose 22; this was the single most popular pick, accounting for 9% of the sample.
But at what point do you stop second-guessing your opponents? You can continue these iterations until you get to zero (the 'Nash equilibrium'), but this implies that you assume that all players are rational, and that all players assume all other players to be rational.
The actual average number picked was 26, giving a two-thirds average of 17.3 to win the game, and representing an average of 2.8 steps in the thinking process.
Playing the market
If we're playing the market, rather than investing in businesses, this is the sort of game we're playing.
The two ideas are not mutually exclusive, of course: The ideal 'outer' for an investment combines not just an improved outlook for the business but also an exaggerated appreciation of that outlook by Mr Market.
But if your investment case is based purely on the latter, depending on a 'greater fool' to take it off your hands later at a higher valuation, you are playing a very risky game. The dotcom boom was a classic case, but there are other examples and we don't have to go back that far to find them.
Next week I'll look at Viz magazine's perspective on quantitative easing, and how it relates to Friedman's theories on inflation.
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