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Wall Chair in Corporate Law and Governance
University of Missouri Law School

Thomas A. Lambert is the Wall Chair in Corporate Law and Governance and Professor of Law. Professor Lambert’s scholarship focuses on antitrust, corporate and regulatory matters.

Popular Media

Planet Money on Kittens, Keynes, and the Stock Market

Prompted by this post at Cafe Hayek, I recently participated in a web experiment sponsored by NPR’s Planet Money.  I was asked to watch three short animal videos and vote for the animal I found cutest.

The videos were all pretty cute.  One featured a polar bear cub sliding along the ice with its mother.  Another featured a loris — a wide-eyed adorable creature with which I was not familiar — being tickled under its arms.  I voted for the critter in the third video, a tiny kittenthat would throw its arms back in surprise when its handler made a certain noise and motion.  That dang kitten was excruciatingly cute.  I watched the video several times.

Earlier this week, the folks at Planet Money explained their experiment.  They were, they say, testing John Maynard Keynes’s famous “beauty contest” analogy.  In Section V of Chapter 12of the General Theory, Keynes explained that investors picking stocks are a bit like participants in a type of newspaper beauty-picking contest that was apparently common in England in the 1930s:

[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that 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.

So what has this to do with those cute critters?  Unbeknownst to me when I voted for that adorable kitten, I had been placed, along with half of the 12,000 participants, in “Group A.”  We were asked to vote for the cutest animal.  The other experimental subjects, those in Group B, were asked to vote for the animal they thought participants would say is cutest.  They were, in other words, asked to act as a judge in the sort of “beauty contest” (here, “cuteness contest”) to which Keynes analogized.

My kitten prevailed in both polls (go kitten!), but by substantially different margins.  Of the participants asked to vote for the animal they thought cutest (members of Group A), 50 percent voted for the kitten, 27 percent for the loris, and 23 percent for the polar bear.  The participants directed to vote for the animal they thought would generally be perceived as cutest (members of Group B) voted for the kitten about 75 percent of the time, with the loris and the polar bear capturing 15 percent and 10 percent of the vote, respectively.  If we assume an even distribution of preferences among the members of the two randomly segregated 6,000-person groups, then it seems that a great many members of Group B did not vote for the animal they personally deemed cutest.

The folks at Planet Money claim that they were “trying to get a better sense of how the stock market works.”  They say they were trying to “test” Keynes’ observation and its implication, which is that the stock market often fails as a measure of listed firms’ fundamental values (i.e., investor expectations about the future free cash flows the firms will generate), because investors focus not on expectations about actual future earnings but instead on other investors’ sentiments.  In actuality, the experiment in no way confirms the accuracy of Keynes’ analogy or says anything at all about how the stock market actually works.

Keynes’ notable claim was not that participants in newspaper beauty-picking contests tend to disregard their own preferences and pick according to expected majority sentiment.  Of course they do.  That’s how they win.  Keynes, though, asserted something more controversial:  He contended that investors do, in fact, act like participants in a newspaper beauty-picking contest when they make investment decisions.

The Planet Money experiment may “prove” the incontrovertible claim that a person who is rewarded for following herd mentality will tend to disregard his personal preferences when they diverge from his expectations about majority preferences.  But it says nothing about whether investors do, in fact, merely follow the herd when they are making investment decisions.  In the experiment, many members of Group B disregarded their own preferences in selecting the cutest critter, but that’s because they were directed to do so.  They weren’t simply given a sum of money to “invest” in cute creatures and told that they could keep any profits.  Had they been, a great many who voted for the kitten or polar bear cub might instead have invested in the loris, recognizing that kittens and baby polar bears — while cute today and likely to be quite popular in the short-term — will eventually grow into decidedly less cute cats and mama bears, while lorises, with their huge doe-eyes, tend to retain their cuteness over time.  An investor who bought a bunch of now-hot kitten stock and failed to dump it before the kitten turned into a gawky adolescent could lose his shirt.  Long-term investors, especially institutional investors, would be particularly loathe to invest in a critter whose popular appeal was likely to change so quickly and unpredictably.  (As a proud cat owner, I can attest to the fact that the creatures transition from cute kittens to ungainly young cats in a very short period.  A kitten investor would have to be an awfully scrupulous monitor!)

This is not to say that stock market bubbles — and asset bubbles more generally — do not occur.  Of course they do.  And they are frequently occasioned by precisely the sort of thinking Keynes imagined — i.e., investors, spotting a hot area of investment, disregard their own expectations about the investment’s fundamental value and instead assess the likelihood that they will be able to sell the investment, for a profit, to some “greater fool” in the future.  I’ve blogged about this phenomenon several times and believe it was responsible for the recently deflated real estate bubble (especially since the investors who originated loads of bad mortgages knew there were congressionally created greater fools — Fannie Mae and Freddie Mac — standing ready to buy their bad investments!).

The Planet Money discussion, though, was misleading on a couple of fronts.  First, as noted, the cute animal experiment didn’t really test — and therefore cannot “prove” — Keynes’ descriptive claim about how investors make investment decisions.  Second, the discussion suggests that investors generally take the “greater fool” approach when making investment decisions — not simply that asset bubbles occasionally occur — and it therefore insinuates that the stock prices are generally a poor gauge of firms’ fundamental values.  There’s a good deal of empirical evidence suggesting otherwise.  For a wonderfully lucid summary of it, pick up the brand new (2011) edition of Burton Malkiel’s classic, A Random Walk Down Wall Street.  Malkiel acknowledges asset bubbles (colorfully and in great detail!) but recognizes that they are the exception, not the rule.