Greater Fools and Beauty Contests

"Who's the more foolish, the fool, or the fool who follows him"

Star Wars fans may recognise these words as the ones uttered by Sir Alec Guinness in his role as Obi-Wan (Ben) Kenobi in Episode IV: A New Hope.  This thought-provoking concept forms the basis of one of the earliest attempts to explain financial bubbles in terms of social psychology - greater fool theory.

The idea here is that an investor (the fool) will pay for an asset, knowing full-well that the price is too high.  However, he has confidence in being able to sell it on at a later date, at an even higher price, to another investor (the greater fool).  Although popular among laymen, the theory lacks any empirical clout.




A similar concept is that of the Keynesian beauty contest. 

The idea is to imagine a competition where you are asked to pick the six most beautiful women from a larger pool.  If you pick the 6 most popular women, as decided by every entrant in the competition, you win a prize.





Keynes noted that there are different orders of strategy to selection:

Order 1) 
Pick the women that you find to be most beautiful

Order 2) 
Pick the women that you think other people will find to be most beautiful

Order 3) 
Pick the women that you think other people will think other people will find to be most beautiful

(eh???)

In otherwords, in the third order, you assume that everyone else is chosing based on what they think the average will be i.e. they will selecting using the second order rather than the first.  In the same way, the fourth order would assume that everyone else is thinking in the third order and so on. 

Keynes believed that the same principal applied to financial markets, whereby traders valued prices at the level they preceived to be the average opinion, rather than what they thought was the actual, intrinsic value.

Both of these theories seem to imply that dealer behaviour is not always consistent, leaving room for speculation and the inflation of a bubble.