The Tesla Stock Beauty Contest
I’ve been seeing several instances of Keynesian beauty contests. My one sentence summary of such a contest is “the value of X being based on your perception of what other people think.”
Epsilon Theory explained why, in finance, the bets are the game. It’s the equivalent of a bunch of people deciding to bet on the Jets against the Patriots, and those bets determining the winner of the game.
We’re all coming to the realization that stock prices work the same way. They’re not based on fundamentals.
This is a more detailed writeup on Keynes’ theory:
“Instead, Keynes thought that professional money managers were playing an intricate guessing game. He likened it to a common newspaper game ‘in which the competitors have to pick out the six prettiest faces from 100 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 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 . . . 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.’”
I remember my first day of taking Game Theory in college. There was a class exercise at the end of lecture where someone was going to win a prize. Everyone had to guess a number from 0 to 100, and the winner was the person whose guess was closest to two thirds (66.6%) of the average of all guesses.
I started doing the math in my head. If the average of random numbers between 0 and 100 is 50, then two thirds of 50 is roughly 33. However, surely the class is filled with smart people, so everyone would guess 33. If that’s the case then I needed to go a step further and guess 22. Well, I’m guessing many other people are thinking the same thing, so another step would be 15. Eventually the only rational thing to do is guess 0.
My final guess was 3, and the winning guess was 12.
Where have we seen this exact contest play out in real life? Tesla’s stock. If you recall, several months ago Tesla did a stock split. All that means is that existing shares were split into smaller shares, but the total market capitalization of Tesla was the same. Therefore, a 2 for 1 stock split with a share price of $100 should create two shares each worth $50. Fundamentally, the price should not rise above $50 just because the stock is “more affordable.” Yet, the stock price increased. Here’s why:
“The feeding frenzy on Tesla has nothing to do with that handful of rubes buying the stock because it’s more ‘affordable’ after the split. It has something to do with traders buying the stock because they believe the story that there will be rubes buying the stock because it’s more ‘affordable’ after the split. And it has everything to do with traders buying the stock because they believe that other traders believe the story that there will be rubes buying the stock because it’s more ‘affordable’ after the split.
This is the Common Knowledge Game in action. It is the power of the crowd watching the crowd. It is the power of – not what you think is true, and not what you think the crowd thinks is true – but of what the crowd thinks the crowd thinks is true.”
What is the solution? Not participate? Think two steps ahead? I don’t know. What I do know is that being aware of this concept is a good start.