Markets often have little to do with logic

By James McCusker

When politicians start talking about reform, hide your wallet. When economists start talking about beauty, hide your eyes.

There are some, well, beautiful exceptions. John Maynard Keynes did write effectively about “corporate beauty contests,” and the role they play in financial markets. In so doing, he identified the basic elements of the two basic types of investment analysis still in use today: fundamental and technical.

Keynes is best known these days as the economist whose ideas have been disinterred to support our love affair with monumental federal deficits. It is pretty certain that were he alive he would be very uncomfortable with that reputation.

What is not well remembered about Keynes is that he was an experienced and extremely successful investor — of his own money and of funds entrusted to him by others, including Oxford University. He understood the economics, the psychology and the math of financial markets. His perspective on the evaluation and selection of investments can be seen in his likening the process to the kind of beauty contest that used to be run in newspapers and magazines. In these, to win a prize, you must sift through a large group of photographs to pick the winning candidate for, say, the Miss Antarctic Molasses title.

If you are just voting for your favorite, it is simple. For those competing to pick the winner, though, it gets complicated. As Keynes wrote, “… 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 isn’t enough to make your best judgment on the facts as you see them. To come up a winner, you have to be able to read the minds of the other contest participants.

Keynes established two things in his analysis of this kind of contest: There was no prize for being right about the one who was most beautiful or most attractive in any sort of absolute terms, and the prize went to whoever could guess the contestant that the others would pick as the winner.

In stock markets, focusing on a company’s qualities is called fundamental analysis — the same thing as trying to select the most attractive candidate based on her photograph. We call focusing on how the company’s stock is likely to move in relation to broader market and economic trends technical analysis, and it is the same as focusing on how we believe that other people are going to vote in a beauty contest.

There is something inherently silly about focusing on others’ intentions, of course, especially as it becomes increasingly a guessing game involving abstractions piled on abstractions — and guesswork passed off as science.

Keynes was right, though, to recognize that psychology, uncertainty and a gambling instinct are important elements of financial markets; and at times every bit as important as logic, reason and mathematics. Today’s volatile markets are testament to that.

A recent study by researchers at Duke University and published by the National Bureau of Economic Research illustrates another dimension of an economic reality: Business decisions are not based on reason alone. Other factors, including instincts we might not be aware of, have a part to play, too.

What the researchers did was to set up experiments using photographs of corporate CEOs and non-CEOs that were examined, compared and ranked by different sets of participants. What they found out was that CEO compensation is partly based on appearance. On average, the pay of chief executives who looked competent was 7 percent higher than what the others received.

That wasn’t so surprising. Most of us went to high school after all, and understand the appearance-equals-reward system. But the researchers also found that the larger the corporation, the more likely it was that the CEO would look the part.

This indicates that as a corporation grows, its management becomes less of a meritocracy and more of a beauty contest that brings significant declines in economic efficiency.

Corporate beauty contests may be just one of the ways that instinctive, high schoollike behavior patterns drive both financial markets and corporate management. At a time when reform is in the air, this should tell us that there are limits not just to their economic efficiency but also to our efforts to regulate and reform them as well.

More than anything else, though, it should remind us that we don’t know everything. We have learned a lot about markets and a lot about business management over the years. But just as there are imperfect markets and imperfect organizations, we have imperfect knowledge about how they actually work.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.