Issue: Behavioral Economics
Short Article: Why the Stock Market Resembles a Beauty
Contest
By: Victoria Finkle
Pub. Date: May 9, 2016
Access Date: July 28, 2017
DOI: 10.1177/237455680210.n6
Source URL: http://businessresearcher.sagepub.com/sbr-1775-99729-2729618/20160509/short-article-why-the-stock-market-resemblesa-beauty-contest
©2017 SAGE Publishing, Inc. All Rights Reserved.
©2017 SAGE Publishing, Inc. All Rights Reserved.
Share prices are often in the eye of the beholder
Executive Summary
Behavioral economists cast doubt on the efficient-market hypothesis, and say people’s biases and other errors can influence stock prices.
Full Article
The efficient-market hypothesis has long been a darling of the financial world. The theory, formalized by U.S. economist Eugene Fama in
1970, argues that there’s no “beating the stock market,” because share prices automatically incorporate existing information and therefore
only move on the basis of genuinely new data. Over the long term, those prices will represent a firm’s true value. 1
Although the concept is still popular today, growing evidence from the world of behavioral finance suggests that the markets might be
prone to errors and biases, much in the way humans fall short of the ideal set out by the model of the “economic man,” who is fully rational,
self-interested and disciplined.
“Getting a loan from a bank is different from buying an orange,” says Todd Knoop, an economics professor at Cornell College in Mount
Vernon, Iowa. “When you buy an orange you pay for it today and there’s not that much uncertainty about it. In finance there’s so much
uncertainty, because finance takes place over time and into the future. In psychology, the research suggests that when people make
decisions about the future, they often have biases in their forecasting.”
Clifton Green, a finance professor at Emory University’s Goizueta Business School, says that because the efficient-market hypothesis is
so well established, economists are trying to figure out where—and how often—the theory falls short.
“Market efficiency is not dead,” he says. “We don’t write papers anymore when it works, because that’s the null. We assume that, and we
write papers when it’s not working.”
Traders on the floor of the New York Stock Exchange. Behavioral economists say that the traditional efficient-market
hypothesis overlooks the ways in which human biases and errors can affect investment decisions. (Michael Nagle/Bloomberg
via Getty Images)
Most financial economists would agree that individuals can make bad investing decisions that will affect the markets, at least until a few
“smart” investors trade against them and stock prices “correct” in response, back toward their “fundamental” value. 2 But still being
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Short Article: Why the Stock Market Resembles a Beauty Contest
SAGE Business Researcher
©2017 SAGE Publishing, Inc. All Rights Reserved.
debated is whether psychological biases and other factors can lead to pricing anomalies over longer periods of time. People tend to be
overconfident in their own bets, distracted by news stories and prone to “herding,” when they follow the latest fad—sometimes right over a
cliff.
One early skeptic of the idea that the stock market always reflects real value was British economist John Maynard Keynes, who argued
that “day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend
to have an altogether excessive, and even an absurd, influence on the market.” 3
Keynes famously theorized that the stock market acted more like a newspaper beauty contest in which players must pick out the six bestlooking faces from 100 photos, with the prize awarded to the competitor whose choices best reflect the preferences of everyone playing.
Similarly, in the stock market, investors respond more to each other than to the fundamental assets being traded, he said.
“Each competitor has to pick, not those faces that he himself finds prettiest, but those that 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,” Keynes wrote in his 1936 book, “The General Theory of
Employment, Interest and Money.” “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.” 4
American economist and Nobel Laureate Robert Shiller popularized some of these concerns in recent decades with his work on
speculative bubbles in the stock market, including the busts in the dot-com world in the late 1990s and the housing industry in the mid2000s.
“A key Keynesian idea is that the valuation of long-term speculative assets is substantially a matter of convention, just as it is with
judgments of facial beauty,” Shiller said in his 2013 Nobel Prize lecture. “Whatever price people generally have come to accept as the
conventional value, and that is embedded in the collective consciousness, will stick as the true value for a long time, even if the actual
returns fail for some time to live up to expectations.” 5
Somewhat ironically, Shiller shared the Nobel with Fama for their collective (if often opposing) work on asset prices and stock movements,
along with another financial economist, Lars Hansen. 6
About the Author
Victoria Finkle is a freelance journalist based in Washington, D.C., who focuses on business, banking and public policy. She has written
for the New York Times, Inc. magazine, Bloomberg BNA and Washington Monthly, and previously worked as a staff writer for the American
Banker newspaper, covering Capitol Hill and consumer finance.
Notes
[1] Richard H. Thaler, “Misbehaving: The Making of Behavioral Economics,” 2015, pp. 206-207.
[2] Ibid., p. 205.
[3] Richard H. Thaler, “Keynes’s Beauty Contest,” Capital Ideas, Sept. 2, 2015, http://tinyurl.com/jnco5ph.
[4] Ibid.
[5] Robert J. Shiller, Nobel Prize Lecture, Dec. 8, 2013, http://tinyurl.com/jcpjkdh; also see Robert Shiller, “The Beauty Contest That’s
Shaking Wall Street,” The New York Times, Sept. 3, 2011, http://tinyurl.com/hmrdjj8.
[6] Rich Miller, Joshua Zumbrun and Niklas Magnusson, “Fama, Shiller, Hansen Win Nobel Prize for Asset-Price Work,” Bloomberg, Oct.
14, 2013, http://tinyurl.com/hfg4phv.
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Short Article: Why the Stock Market Resembles a Beauty Contest
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