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Agent MattPosted: Jan 14, 2011 - 10:45

Genuine American Monster

Level: 70
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On the surface, Planet Money's first-ever economics experiment was all about cute animals. (You can see the experiment here.) But we were really trying to get a better sense of how the stock market works.

We got the idea from John Maynard Keynes. Back in 1936, he described the stock market as a particular kind of beauty contest. You see a bunch of women's faces, but you're not supposed to say who you think is prettiest. You're supposed to guess who everyone else will think is the prettiest.

In the market, Keynes argued, it doesn't make sense to invest in the company you think is best. It makes sense to invest in the company that you think other people will think is best. Because if everyone else invests in a company, the price of its stock will rise.

Of course, when everyone does this, it leads to a slippery investment world. "We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be," Keynes wrote.

Pietra Rivoli, a professor at Georgetown's business school, explains the problem with a market like this: "The key danger is that nobody's really thinking."

With her guidance, we tested Keynes's idea. Instead of photos of people, we used videos of cute animals. About 12,000 people participated. When they came to our experiment page, they saw three videos that showed a kitten, a slow loris and a baby polar bear.

Half the people in the experiment were asked to pick the animal they genuinely thought was the cutest. And half were asked to pick the animal they thought everyone else would find the cutest. Here are the results:

(Click link for images)

Marla Wood, a Planet Money listener from Colorado, was assigned to the second group. She thought the loris was cutest. But she picked the cat, because she thought that's what everybody else would pick.

If the stock market were filled with Marlas, you could have a huge kitten bubble, even if no one thought kittens were cute.

It might look something like the housing bubble. People kept buying houses — not necessarily because they thought home prices made sense, but because they thought everyone else would keep buying houses at any price.

As it happens, Marla guessed right, as did 75 percent of the people in her group. But 25 percent of people got it wrong. They thought the loris or baby polar bear would win. If this were a cute animal stock market, that could throw off prices.

Rivoli says when she hears on the news about the stock market doing this or that, she sometimes thinks: beauty contest.

"There's been some academic research on this that says there's a lot of price movement in individual stocks and in the market as a whole that we can't explain with fundamental, rational stories," she says.

This doesn't mean the stock market is totally nuts. Over long stretches of time, Rivoli says, even Keynes would probably argue the stock market gets things right. All bubbles eventually pop.

UPDATE: Several of you have asked in the comments why the chart on the left adds up to 101%.

The full results for Group B were:

Kitten: 75.67% (4,517 votes)
Slow Loris: 14.73% (879 votes)
Baby Polar Bear: 9.6% (573 votes)

Rounding up to the nearest whole percentage point, yes, you'd get a total of 101%, but including decimals, it's 100%.

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