A Beauty Contest: Why Stock Prices Are So Volatile

Since the stock market works just like an auction, stock prices are essentially determined by demand and supply forces. But what are some of the factors that affect demand and supply of stocks?

Performance of the company

One of the primary measures of the performance of a company is its earnings. However, profits alone do not reflect the full picture of the health of the company. In fact, there are many big firms in the market today that have yet to become profitable. Uber is one of them. Although profitability is the ultimate goal, we also need to look at other important factors to assess the performance of a company (especially if it isn’t profitable yet). These include the quality of its product, its investments in research and development, as well as the quality of its management.

Market Sentiment

Bulle und Bär (Bull and Bear) sculptures in front of the Frankfurt Stock Exchange

The two buzzwords here are bulls and bears. A bull market is one in which stocks prices have seen sustained growth. Typically, this is a period of strong economic growth and is accompanied by increased investor confidence. Conversely, a bear market describes falling stock prices amidst a period of fear and uncertainty. However, there are different theories about how investors may behave in response to market sentiments. The Animal Spirits Theory proposed by the economist John Maynard Keynes is a famous example. This theory supports the belief that investors are guided by their emotions, especially during times of uncertainty. For instance, an investor may sell his stocks during a bear market in fear of stock prices falling even further.

External events

Events such as the release of a company’s earnings report or an imminent economic recession can significantly influence market sentiments. Investors use these events to predict the direction of stock prices in the near future. Sometimes, we can even observe certain trends. Let’s take a look at Apple. Historically, Apple’s stock price increases in the months leading up to the WWDC each year (a conference where Apple releases new products).

WWDC 2020 (Jun 22 – Jun 26) Yahoo Finance

The Keynesian Beauty Contest

These factors explain why stock prices change, but not why they fluctuate. If the stock market were to be so causal and rational, then why do price directions change so dramatically in a short span of time?

To answer this question, let’s do a thought experiment:

In a newspaper contest, readers were asked to select 6 most attractive faces from 100 photographs. Readers who choose the most popular faces will win a prize.

What would be your strategy? You could naively pick the faces that you find most attractive. A more sophisticated strategy would be to pick the faces that you believe the average person would find the most attractive. The latter strategy appears to be superior, especially if you think that your perception of beauty do not align with what you think is the general perception. You could also take it one step further by thinking about what the general perception of the general peception would be (and this process can go on and on).

This is also known as the Keynesian Beauty Contest, a theory introduced by Keynes in his book The General Theory of Employment, Interest and Money. He believes that investors are constantly trying to one-up other investors by trying to predict their moves. It is perhaps this instinct that leads people to invest in a company that they think would appeal to the average investor, even if it does not seem that good to them. This behavior of guessing can cause wild fluctuations in stock prices.

In view of this, do you think there is a winning strategy? To answer this question, we need a more concrete example (with some numbers). Consider a similar thought experiment:

Guessing two-thirds of the average

In a room of people, each person guesses (a number between 0 and 100) what they think two-thirds of the average of all guesses would be. For instance, if a person thinks that the average is 30, then he would choose 20. (This game was invented in 1981 by Alain Ledoux, editor-in-chief of the French magazine Jeux et Stratégie )

We can start tackling this problem by eliminating some impossible choices. Firstly, one should not guess any number greater than 66 2/3 (i.e. 66.666…) because this is the largest possible average (if everyone chooses 100). Assuming that everyone in the room acts rationally, they will know that every other guess will be at most 66 2/3. This then implies that one should guess a number that is no greater than two-thirds of 66 2/3, which is 44 4/9 (i.e. 44.444…). By iterating this reasoning, one would arrive at the conclusion that 0 is the correct choice.

It seems like there is indeed a correct answer. But we must remember, we have made the assumption that everyone in the room acts rationally. In a real-life context (such as the stock market), this would almost never hold true. Indeed, our line of reasoning will break down as long as one person in the room fails to act rationally. If one person chooses a number greater than zero, it is clear that the average will necessarily be greater than zero.

What does this mean for stock markets?

Given that we can neither assume perfect rationality nor read the minds of other investors, picking a winning strategy is an impossible task. This is why even the most well-thought-out investment strategies can fail. But does this mean that there is nothing we can do about it and that investing is necessarily reduced to a guessing game? In my opinion, the wisdom of economists like Keynes can help us understand some of the trends we see in the stock market today and prevent us from acting irrationally.

In March 2020 the stock market crashed amidst the onset of a global pandemic. But it also rebounded in record time, making this crash one of the shortest in history. Why did this happen? The plunge in stock prices was inevitably due to fear that was brought about by the uncertainty as countries were locked down and many businesses were shut down. Investors who feared that the value of their investments would be eroded sold their stocks in a panic. However, there were also anticipative investors who pounced on this opportunity to buy the dip. They knew that for many resilient firms, the fall in stock prices was mainly driven by irrational fear rather than fundamental changes in the businesses.

Once again, the importance of doing research and understanding your stocks must be reiterated. It would be foolish to let your emotions be swayed by the (possibly) irrational sentiments of others. It would be even more foolish to let your investment decisions be swayed by these emotions. We need to look past short term fluctuations in prices and focus on the fundamental value of stocks instead.

Image references

Header: Public Domain Pictures
Bulle und Bär: Wikimedia

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