Animal Spirits and Beauty Contests

This is a short extract from my book Financial Speculation. Its a quick look at two key components to successful investing as espoused by John Maynard Keynes. To me it is timeless advice that I try to adhere to.

Animal Spirits and Beauty Contests
Perhaps as a final observation on Keynes activities we should consider the fact that he never published any work on his secret investment techniques etc., though his views and attitudes are well documented. In particular Keynes wrote interestingly about speculation and what he called ‘Animal Spirits’. He noted that most market players are driven by optimism rather than mathematical expectation, and he was an early observer of one of the most corrosive of market practices – excessive activity or overtrading. He correctly realised that when under stress people often adopt active roles for the sake of it. Such is usually a substitute or a displacement activity, or as a way of trying to shake off the stress. Many people feel stress when involved in financial markets and they often alleviate this with quite manic trading activity. Bizarrely they trade even more ferociously when in fact they should calm down and draw back. Though in fact this only one side of the ‘behavioural’ coin in market psychology, the other big problem is curiously the exact opposite, freezing and being unable to act to stop losses from running out of control. Trading like so many things requires a happy medium of activity – few of us seem to be able to do this on a consistent basis.

Keynes also saw the problem of market speculation and prediction as akin to trying to guess who would win a beauty contest; he compared speculation to a newspaper beauty contest, where one is asked to pick out the prettiest faces among hundreds of photographs; and also most crucially to predict which is the most popular choice of all the entrants in the competition. So for example you may pick contestant number 54 – but sense that girl number 23 is the most popular. This is akin to looking at say the FTSE 100 list of stocks and you decide that you really like BP – but realise that the market really likes Vodafone.
Keynes held that to be successful in investment we have to choose not the ones we think are the “prettiest”, but the ones that we think everyone else will select. This piece of market thinking demolishes much of the supposed value of market analysts and commentators – what’s the point in knowing the best oil company in the market if all the price action is in say transport stocks? When Keynes first postulated this idea in the 1930’s it was considered somewhat radical and certainly didn’t conform to the standard views of rationality and assessing financial markets and assets in terms of fair value etc. Over time though, this idea has been developed further, now with a lot of interest being shown in market behaviour and psychology – though many market players and intermediaries seem to ignore it.
Finally, once again Keynes seems to prove the rule that successful market operators let their results speak for themselves. Only the also rans and hopefuls promote their ‘secret’ investment theories and systems, the successful just do it.