Over at TheMoneyIllusion I received the following comment:

Macro trading is not about getting it right, it is about getting what others think is right. And that can be almost anything …

That reminded me of Keynes’s famous claim that successful investing was like guessing the winner of a beauty pageant. You don’t try to pick the prettiest woman, but rather the woman that you think others will find pretty.

That’s a clever line, but I don’t think it’s correct. I believe markets are roughly efficient, which means that it’s very difficult for people to forecast (risk-adjusted) excess returns. But let’s say I’m wrong; how would you go about doing so? One option would be to try to forecast the future type of mass hysteria that the public will succumb to. The other option would be to identify current irrationality in the investment community, which will eventually fade away, as new information makes it clear that their forecasts were unrealistic. I believe it would be easier to notice in 1999 and 2000 that tech stocks were too high due to “irrational exuberance,” than to forecast back in 1994 that there would soon be a bout of irrational exuberance.

If you look at successful investors like Warren Buffett, they generally don’t try to buy stocks that they believe will be overvalued in the future, rather they try to buy stocks that they believe are currently undervalued. Those are not easy to spot, but the alternative approach is even more difficult.

If we return to the beauty pageant example, Keynes’s analogy doesn’t really make any sense. For example, to make money betting on the winner of a beauty pageant, you’d need to do much more than predict which lady other bettors will find attractive, you’d have to predict how their views of relative beauty would evolve after the pageant. That’s because the starting odds on each woman winning would already reflect the public’s perception of their relative attractiveness. You’d need to predict how that public appraisal would change after the talent and swimsuit competitions. I suppose that’s possible, but it’s more about predicting “fundamental values” of beauty.

If we insist on a beauty pageant analogy, here’s the one I’d use. Suppose the average beauty pageant gambler bets on the basis of the stock photos provided by the pageant to the press. That’s the “public information.” If you were Warren Buffett, you’d want to send detectives around observing the women in their daily lives, to get a better overall appraisal of their beauty and poise than you’d get from a single stock photo. (Or their ability to talk convincingly about the need for world peace.) That’s what I mean by “fundamental” beauty. You don’t want to forecast what others think, that’s already embedded in the price, you want to forecast the TRUTH, which is what others will come to think once more information is available (in this case the pageant itself, in the world of stocks that would be how profits play out over an extended period of time.)

In both cases you are basically trying to forecast what people will learn over time. Of course my analogy is far from perfect, as even after a pageant you could argue that perceptions of beauty are more subjective than corporate profitability.

PS. In a future post I’ll explain what’s wrong with claiming, “the market can stay irrational longer than you can stay solvent.”