I’m starting the New Year by reading some of the classics to develop a deeper understanding of some investment concepts. Among the concepts I’m researching… is the Keynesian beauty contest.

Economist John Maynard Keynes used the “beauty contest” to explain why stock prices move up and down.

While Keynes is deservedly recognized for his economic insights, he was also a great investor. From 1924 to 1946, he managed a fund for King’s College from 1924 to 1946. Over that time, the benchmark stock market index in Great Britain declined 15% as the Great Depression and World War II weighed on the market. Keynes delivered a total return of more than 1,160% during that time, an average annual return of about 12% a year.

#-ad_banner-#To explain how he thought about the stock market, Keynes compared investors to readers of a newspaper that sponsored a beauty contest. (This book was published in 1936, so the description of the beauty contest is quite sexist — but it’s still valuable to think about in an economic context.)

In the contest, readers are asked to choose the six most attractive women from a hundred photographs. Those who picked the most popular women are then eligible for a prize.

As Keynes explained, this is not really a contest about who readers think the most beautiful woman is:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that 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 practice the fourth, fifth and higher degrees.”

In other words, in the stock market, naive investors think about what a stock is worth. More sophisticated investors think about what others think a stock is worth, and so on.

Turns out, Keynes was on to something here… National Public Radio’s “Planet Money” tested the theory by having its listeners select the cutest of three animal videos. The listeners were broken into two groups: One selected the animal they thought was cutest, and the other selected the one they thought most participants would think was the cutest.

The results showed significant differences between the groups. Half (50%) of the first group selected a video with a kitten, compared to 76% of the second selecting the same video. Individuals in the second group were generally able to disregard their own preferences and accurately make a decision based on the expected preferences of others.

The results were considered to be consistent with Keynes’ theory.

Why This Matters
This is important to remember right now. We need to start thinking about how other investors are thinking. Many will be opening brokerage statements soon and seeing lower-than-desired balances. We need to think about how they will react. Many will remember 2008, and some may sell, fearing even steeper losses.

That’s just a factor that adds to the risk of the current market. It’s simply a Keynesian beauty contest right now, and we need to be prepared to benefit from how investors will be acting in that type of contest.

For now, that means I will remain cautious and look for trades with a large margin of safety. Thanks to the strategy we use over at Income Trader, we don’t have to run for the hills at the first sign of market weakness. Our strategy of using options for income is one of the most time-tested, conservative ways of earning income — in any market environment.

That’s one of the main reasons we’ve been able to book 244 winning trades out of 267 so far — a 91% win-rate. Of course, we didn’t get them all right. But when our pick in the “beauty contest” isn’t a winner, we get out fast… in fact, we averaged only -4.8% on our losing positions in 2018, while booking an average annualized gain of 35%.

Regardless of whether you’re using our strategy or not, I encourage you to keep this idea as you start off the year. Because, to borrow another phrase reportedly spoken by Keynes, the market can stay irrational longer than you can stay solvent. (And if you’d like to learn more about our strategy, go here.)