Philip Pilkington: Bubbles and Beauty Contests – To What Extent is Keynes Relevant to Investors?

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

Of Masters and Slaves

There are some strange and interesting passages in Keynes’ General Theory of Employment, Interest and Money – and it is these, I think, that give it its deserved status as a classic. Many of these passages are the tangential reflections of a man – who we should not hesitate to call a genius – on his subject matter. And it is these passages that truly make Keynes what he was: a wise man.

One of the most fascinating passages on the so-called Keynesian beauty contest is worth quoting here in full.

[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. And there are some, I believe, who practise the fourth, fifth and higher degrees. (GT, Chapter 12)

Is this an economic point that Keynes is making? To an extent, yes. But at a deeper level it is an ontological point. What he is really referring to is how investors situate themselves vis-à-vis one another as people. If applied to many of our interpersonal relations Keynes’ example would be just as accurate. The fact is that people often – if not always, albeit unconsciously – think about what others are thinking about before they make decisions. Some might call this ‘herd behaviour’, with all the pejorative connotations that calls up; but the fact is that we all engage in this sort of activity to some extent (if not completely) – and it simply remains to be seen how conscious a given individual is of it.

Okay, so maybe there are some people that do not think in such reflective terms, but they are few and far between. People, for example, who believe that they have found some inherent ‘law’ to which the market adheres and who then place their bets based in accordance with this supposed law. Hardcore gold bugs would be a fine example of this. They tend to believe that they have worked out a fundamental Truth of some sort and refuse to take into account that the price of gold may be driven by a Keynesian beauty contest dynamic (i.e. expectations built upon expectations).

Then there are the other extreme. These are the people that, in Keynes’ words, “practice the fourth, fifth and higher degrees” – that is, people who try to work out what other people are working out about what other people are working out about what other people are working out. Do these people exist? No, this is far more likely to be Keynes’ own fantasy – an intellectual thought experiment projected onto reality. In all likelihood there are probably no investors that truly go beyond the third degree which, as Keynes says is, “where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” One gets far too dizzy after Keynes’ ‘third degree’ to think about popular opinion in a way that would produce any really useful information. (Although one could imagine thinking at the ‘fourth degree’ given a singular ‘opponent’, but this is the exception not the rule in investment).

Thought experiment or not, it is interesting – even enticing – to consider how far you can push this logic. This is because this logic, as indicated above, says something fundamental about human psychology – nay, human ontology. We believe in these Others out there with varying degrees of mastery, opinions and information. Some, like the hardcore gold bugs, strike us as naïve – but some, like the “fourth, fifth and higher degrees”, strike us as Masters that put all our efforts to shame. (The latter are really a myth or structuring principle of course, but ontologically/psychologically speaking that makes them no less real).

This is really a question of power and mastery. Where do we insert ourselves into this great chain? How much do we know vis-à-vis or peers? Where and when do we have one up on our colleagues? How much can we abstract ourselves from the desires of the herd?

All interesting questions which we can only really try to answer to by ourselves. However, there is another important point that Keynes never directly related to his beauty contest, although he was acutely aware of it. I refer to those phenomena known as ‘market bubbles’.

If we look at Keynes’ beauty contest in and of itself we would simply conclude that by trying to ‘get one up on the other guy’ we can always get ahead in the world. Indeed, this is the precise mindset of most professional investors: know your opponent well and use that knowledge to beat him to the finishing line. But is it sufficient?

Beyond the Beauty Contest

Let us step back for a moment. Because perhaps Keynes was, to some extent, fooling himself – at least, insofar as he followed this logic himself in his actual investment activity (which I doubt he did because he was smarter than that and, unlike certain other famous economists of the era, a very successful investor).

What follows are thoughts that are quite difficult to express but there is another writer who has already done so in great detail albeit from a different angle. I refer to the work of the Slovenian philosopher and Lacanian psychoanalyst Slavoj Žižek. Žižek, taking his lead from the French psychoanalyst Jacques Lacan’s work, has written voluminously on these topics as they relate to human consciousness. Since we are implicitly dealing with ontology and consciousness here (shhh… don’t tell the economists!) we will see that we can borrow readily from Žižek’s work.

Yes, Žižek writes, it is true that we watch those around us and try to figure out what they are thinking so we can then both form opinions and strategise. BUT, he claims, we are not REALLY taking an external position as we may think. In truth, we are in no way as detached from the activity as we may like to think we are. We are, despite our meditation and our distance, always already caught up the process that we try to observe.

Take an easy example: an investor who, aware as he is of Keynes and his beauty contest, knows well that the gold market is being driven by the investment expectations of those around him and uses this knowledge to profit from rising gold prices. Are things really as they seem to our Keynesian investor? The investor certainly thinks that he is taking an ‘ironic’ – that is, intellectually detached – position in the market. Our Keynesian assumes that he knows what is REALLY going on – i.e. that gold prices are out of whack and being driven by expectations – but he is just following the herd to turn a profit.

The mistake our otherwise clever investor has made is that he has failed to include himself in his own picture. This is an error of the highest order, the practical consequences of which will be explored in a moment. What this investor has missed is that even in his irony he has ‘fallen for’ the rise in gold prices just as much as his rather more ignorant friend who thinks the price is being driven by fundamentals and blindly tracks the market. Yes, he can tell himself that he is contemplating the whole situation at a distance, but that matters little because he still has skin in the game. In real practical terms there is no difference between our wily Keynesian investor and a boorish market devotee following trends.

Žižek sums this situation up well in his book Looking Awry: An Introduction to Jacques Lacan Through Popular Culture:

[W]e effectively become something by pretending that we already are that. To grasp the dialectic of this movement, we have to take into account that this ‘outside,’ [i.e. the notion that we are just copying something else going on ‘out there’], is never simply a ‘mask’ we wear in public [i.e. when we invest]. By ‘pretending to be something’, by ‘acting as if we were something,’ we assume a certain place in the intersubjective symbolic network [in our example: the gold market], and it is this external place that defines our true position. If we remain convinced, deep within ourselves, that we are ‘not really that’, if we preserve an intimate distance toward the ‘social role we play,’ we doubly deceive ourselves. (P. 73-74)

Dizzy yet? This may seem like a strange point – perhaps even a sophistical one – but I would argue that it is very important. For the stance denounced by Žižek has very practical consequences if it is fully embraced. While we cannot really get the “fourth, fifth and higher degrees” of insight that Keynes referred to – since we can never really get beyond the ‘third degree’ in any meaningful way – there is another path that can be taken that can give us an edge. What we can do is take a good look at our own actions in a given market. This then gives us a very specific advantage: it allows us to recognise our possible exposure to bubbles and other manifestations of financial instability.

As we already said, most good investors are well aware that they are just copying other investors’ expectations – the better they copy, the more profits they will reap. But this very awareness often blinds them to the fact that, regardless of their intellectual detachment, they are very much so in this market and may lose as a result.

Consider a very real example. There were many investors in the pre-2008 Irish housing market who, towards the end, knew there was a bubble – but they kept investing/speculating. Why? Because they thought that they could get out in time. The reason they assumed such mastery on their own behalf was because they had convinced themselves of their own infinite cleverness. They thought that because they picked up on the opinions of others and emulated them, all the while maintaining a ‘distance’, this distance would then allow them to get out of the market before it collapsed. After all, they were wilier than the rest (who they probably assumed to just be automata who did not possess their ‘third degree’ reflection).

What hubris these people displayed and what fools they turned out to be! They were doing exactly what Žižek warns us not to do. They were assuming that the mask they wore – the investments they made – were simply masks that could be taken off once the bubble began to burst. They assumed that everyone else ‘really believed’ in the bubble and that, because they were just ‘wearing a mask’, they could jump ship before the other fools. They had convinced themselves of their own mastery and lost sight of the truth: that they were just a hapless dupe trapped in a market that was about to collapse in upon them.

What makes a good investor is one that can recognise that the positions they assume are very real. And when they undertake an action it does not matter how far they intellectually or psychologically distance themselves from this action because they have still undertaken it regardless. Reality does not care whether you take an ironic distance or not and chances are most other people are undertaking major investments with such an ironic distance too.

Investor George Soros has noted a very similar, if not identical, idea in his concept of ‘reflexivity’. Soros claims that we need to recognise that actions we undertake in certain markets has very real effects on said markets. The fool who thinks he can stay ahead of the bubble is simply one of the herd that is inflating the bubble – the ‘cleverness’ he presumes to possess is simply that by which he blinds himself to this fact. In short, he steps into a shaky market and then allows himself to forget the risks by convincing himself that he, with his ‘third degree’ knowledge, is smarter than the rest of the pack. Meanwhile the rest of the pack think and do exactly the same thing.

In reality, as Žižek says, it is our external place that defines our true position.

Supplement: A Religion of Mediocrity and Failure

These rather obscure reflections have profound consequences for economics as a discipline, especially in its uses in practical matters. Mainstream economics assumes that market participants create equilibrium situations in all markets in the long run. In order to do this mainstream economics has to assume that everyone is copying everyone else perfectly. This is a pathetic assumption and one that has been debunked too often to even be considered here.

But there is another strain of thought that claims to be more sophisticated. This is the ‘asymmetric information’ school of thought that comes out of the work of Joseph Stiglitz. Stiglitz allows for the typical market structures to remain in place but then claims that some participants have more knowledge than others and that this then creates all sorts of problems.

Certainly this is more sophisticated than the market theology that his psychologically devolved colleagues adhere to. But Stiglitz is still in error or, more appropriately, in fantasy land. Stiglitz still assumes ‘knowledge’ on the part of market participants of some sort of underlying fundamentals. But the truth of the matter is that the real ‘knowledge’ that investors think and act off is the ‘knowledge’ they form about the ‘knowledge’ of others. The market is, to a very great, degree a hall of mirrors and it is this that Keynes showed so well.

Good investors know this. But even they, as we showed above, can remain ignorant by assuming too much intelligence on their own behalf and not taking into account their own real situation. But they are certainly ahead of even the most ‘cutting edge’ devotee of mainstream economic theory. Put simply, if an investor followed the mainstream economics models they would not think in Keynes’ terms at all. They would simply follow basic market signals. They would, in short, constitute the weakest members of the herd and would be trampled on by their more Keynesian colleagues.

Indeed, the only school of thought that lives up to the psychology of the professional investor (who are still behind the self-reflective investor that we outlined above) is the post-Keynesian school (the Austrians do to an extent too, but less so – and they tend to have hang-ups about gold and inflation that lead them to fare poorly in real market conditions). The post-Keynesians follow Keynes and assume, as Paul Davidson so eloquently outlined on this site the other day, fundamental uncertainty on behalf of market participants. This allows them to take into consideration the reflective realities of the markets which are among their most important features.

I will end, then, with some investment advice: if you work in the markets and have attained even the level of consciousness that Keynes refers to as ‘third order’ I would suggest that you stick with the economic theories of Keynes and the post-Keynesians (throw in some Soros too, for good measure). All the rest is just dogma that, at the best of times, instructs you to try to gain access to ‘asymmetric information’ and uncritically push your funds into the market in line with this and, at the worst of times, instructs you to blindly follow market signals.

When looked at from this perspective mainstream economics truly is the height of absurdity: it quite literally sets out to teach people how to be terrible investors. At the best of times – that is, when markets are ticking over – it is a religion of mediocrity. At the worst of times – that is, when bubbles are forming and financial instability gathering – it is a religion of failure.

Above photograph is entitled ‘Infinite Reflection’ by Balsamia

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  1. James Hogan

    Is it ok for those of us who are not full-blown capitalists to comment here? There is another way to do some of this stuff which doesn’t involve profit.

    For example, why should any company make a profit on a service that has no competitors, yet delivers a service that no one can live without? And to boot, is involved in one of the basic forces in the entire universe, one that has no substitute?

    This is the delivery of electrical services to your home or business. There is no substitute for this service, no matter how hard you try, there is none.

    The average home gets 240 volts going to its meter. There is no substitute for this force, none. Lest one considers a generator, for a short term fix.

    Here in the south, where I live, we have a co-op which delivers our electricity and gas. I see in the media where these types of cooperation are deemed to be faulty, or something like that, and to be avoided, according to the billionaires who own the media.

    1. Ransome

      They are called public utilities, Keynes was all for them. He thought that monopolies should be nationalized if they provided services needed by the public. In the 1920’s many towns broke their contracts with the holding companies and built their own electric, gas and water works managed by professionals. Their costs dropped by two thirds and the services provided doubled (more and higher wattage street lamps that in total, cost two thirds less per month to operate). It was the wealthy towns that started the trend.

    2. liberal

      A much, much better example than electricity is land.

      People can live w/o electricity (albeit not well). Absolutely no one can live w/o land.

    3. digi_owl

      The basic problem is that assumptions made by neo-classicals, made with the best of intentions mind you, act as a very good leverage for robber barons. This because they make the robber baron arguments seem scientifically rational.

  2. MyLessThanPrimeBeef

    Somehow, I am reminded of this: light seeking light doth light of light beguile.

    I think people are thinking too much.

    ‘The fool who thinks he can stay ahead of the bubble is simply one of the herd that is inflating the bubble’ is no different from the fool who thinks he can stay ahead of inflaton while printing money, for he is simply one of the herd that is stoking inflation.

  3. sleeper

    I’m afraid that there is little investing going on these days.

    The goal of many folks in finance is to collect fees at minimal risk. A good example of this behavior is the high sped computer controlled trading programs.

  4. jake chase

    As one who has had no source of income except financial markets for twenty years, let me suggest that survival in these markets (when playing with one’s own money) depends upon an understanding of who else is playing and under what rules. It is likely that nobody could consistently make money in these markets but for the participation of hired investment managers controlling assets of strangers, whose psychology involves doing no worse than the average of their fellows since doing worse leads to loss of tenure. This herd effect pretty much insures that every established trend goes too far. It produces those recurring stock price waves wherein lies all profit opportunity for those with the courage to buy and sell at all the wrong times. It is easiest to do this when one ignores everything most people consider fundamental, particularly opinions of stock market analysts and celebrity financial gurus, whose ideas have no more validity than the pronouncements of economists or the predictions of sports pundits concerning yesterday’s game between Pittsburgh and Denver.

    When it comes to making money, talk is cheap.

  5. Ransome

    Keynes was a currency trader where different currencies have attractiveness. I read somewhere that 3/4 of currency traders lose money. Perhaps it was just the new ones.

  6. craazyman

    They never do what they say. I read Soros’ book Alchemy of Finance over the holiday break. Why would I do something like that? Never mind.

    He spent the first few chapters setting up his theory of reflexivity, which is sort of common sense codified in a symbolism that looks like quantum physicist Roger Feynman’s arrow diagrams.

    Then he described his trading decisions as he made them during the mid 1980s. It was like a walk down memory lane. He relied on sort of on his theory of reflexivity and on whether his back ached trying to tell him something. Mostly his back ache. Then he got incredibly rich. Which validates everything that came before, even his back. The other thing was that the financial system was always about to come apart at the seems. all the time it seemed. There was always a crisis about to happen. Even then. Like now.

    Contrariana and value investing isn’t really like the Keynes beauty contest anyway. It’s more like an ugly contest. You pick the ugliest face because you know, in reality, she’s just having a bad hair day. Why do you know this and everbody else doesn’t? Because they won’t take the time to see, for a variety of reasons, but mostly haste. It’s not that they couldn’t acquire the knowledge. It’s that they don’t try.

    Jake Chase is correct. All the words about this stuff are mostly nonsense. Even Keynes’. Even mine.

    1. digi_owl

      That Soros description makes me think of the supposed calvinist claim that success is a indication that god loves what your doing, no matter how nasty it may be in reality.

  7. Min

    I think that this post is a bit unfair to mainstream economics. It does not advise investors to follow market signals, it tells them not to try to beat the market, that it is a random walk and there is no free lunch.

    1. Philip Pilkington

      Is there a difference? If you shouldn’t try to beat the market you should… follow the market, no? I don’t see any other options…

  8. pebird

    Keynes was describing derivatives from a human perspective; not only were investors dealing with instruments derived from value, but also had to deal with players who derived their action based on what they thought others thought.

    Love the Zizek references. One way to think about it is that everyone considers themselves to be external to the process. Also, that while you are in your external place wondering how others might act, the others are thinking about how you might act.

  9. craazyman

    Frankly this dude Zizek sounds like a wind bag. Most philosophers do, IMHAIO, especially the Germans and except Albert Camus, my hero the shoe salesman and Nobel prize winner. Andre Malraux was an extraordinarily lucid art critic. The rest of them. yada yada.

    But some folks like yada yada. It’s a free country, for now anyway. So yada on.

    The real question is action. Do you go long Europe now and hope for the 2 bagger in 2 years or do you wait? I’m waiting. Why? I don’t know. I just think it’s going lower before it goes higher. I can’t reason it out with words. I’m losing confidence in words to explain anything. It’s just wordless sensitivities to a certain energetic reality structure that makes the difference, then you just do your best with words after the fact, knowing they’re only approximations. Maybe you have to draw a picture instead.

    1. MyLessThanPrimeBeef

      I wish I could put in words how much agree with that.

      But it’s not possible, I’m afraid.

    1. Philip Pilkington

      Bad academic joke:

      Q. Is there anything less interesting than postmodernism?

      A. Those who criticise postmodernism.

      (Hint: It’s usually a strawman…)

  10. Tim

    Point taken. Kind of. One shouldn’t speak in such absolutes.

    In the real world, I’m a crazed silver investor that sold the last of my silver at $48 per ounce and shorted it dang near $49 per ounce, and I’ve been working my way back in long on the way down to a hopeful bottom between $21-25 per ounce. Pure luck I’m sure…

    In the REAL world, someone that is truly distancing themselves from the market is willing to accept that they are investing in a bubble which does put them fully at risk, and therefore and need to understand what the changing fundamentals are and how divergent expectations and price are from present fundamentals so that when extremes draw near they are already actively divesting themselves of the investment to extract themselves financially and emotionally before it blows up.

    The difference between what you say and what I said is the people you call investors are indeed dillusional and additionally lazy but they do not represent ALL investors.

    There are those that learned from earlier mistakes or the mistakes of others, and are not lazy and have prepared themselves adequately to react appropriately when the time of reversal is approaching, making it possible to bypass that which you describe as inevitable.

    1. Philip Pilkington

      Oh, they exist. But they are the exception rather than the rule. Most investors are Keynesian-style investors who think that they’re cleverer than everyone else and immune from bubble-itis.

  11. David

    Professional investment is like a beauty contest?
    In a way it is but in my view, not how it has been explained.
    If you line up 100 pretty girls and have to choose 1 there are several things you need to know.
    Firstly, is this girl to be your wife for the rest of your life or are you wanting a great time this weekend?
    Secondly, if this girl is going to be your wife, her beauty today becomes much less important than many other factors you will need to consider.
    However, if you are just after a good time this weekend, it might be good to implement some risk management.

  12. Npi

    The word ‘investing’ is like a pig with lipstick, without the lipstick it is called speculation.

    I read an interesting comment the other day that compared financial journalism to warcraft. It is just a game that the bankers want us to play.

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