STEVE INSKEEP, host:
Now, sometimes the stock market goes up and down for no apparent reason. It happens often, actually, and our Planet Money team wondered why. So they tried an experiment based on an idea written down 75 years ago.
Here's NPR's David Kestenbaum.
DAVID KESTENBAUM: A beauty contest. That is how the famous and somewhat eccentric economist John Maynard Keynes described the stock market in 1936. The contest he imagined worked like this: You get a bunch of photos of women's faces and have people vote. The game is to try to pick the winner - not necessarily who you think is the prettiest, but who you think everyone else will pick.
Professor PIETRA RIVOLI (McDonough School of Business, Georgetown University): It made sense for me immediately. And I thought it had such interesting implications.
KESTENBAUM: This is Pietra Rivoli, professor at Georgetown University's McDonough School of Business.
If you think about it, this beauty contest, it is just like the stock market. It makes sense to try to pick the stock you think everyone else will pick, even if you believe the company is a disaster. Because if everyone else picks it, the stock's price will rise.
Keynes wrote about the beauty contest: It's not about picking the prettiest faces, quote, "nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree, where we devote out intelligences to anticipating what average opinion expects the average opinion to be."
PROF. RIVOLI: He is talking about sort of some kind of a strange, exponential psychological process, where I'm trying to figure out what you think and you're trying to figure out what the next guy thinks, and that guy is trying to figure out what the other guy thinks. And the key danger is that nobody's really thinking.
KESTENBAUM: With Pietra's guidance, we tested this out with an online experiment. Instead of a beauty contest, we set up a cuteness contest with three animals.
Twelve thousand people participated. When they came to our website, they were presented with three videos: A kitten being tickled, a slow loris - that's a primate with big eyes - 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. Pietra was in first group.
What do you think is cutest?
PROF. RIVOLI: I picked the polar bear. I like the white fur, and I also thought that the whole skating on your belly on the ice thing as adorable.
KESTENBAUM: And here's someone from Group B, Marla Wood, a listener from Colorado.
Ms. MARLA WOOD: I actually had a hard time finding any of them particularly cute oddly.
(Soundbite of laughter)
KESTENBAUM: What did you think was the cutest, first?
WOOD: I guess the loris was the cutest.
KESTENBAUM: So, but you were asked to pick the animal you thought everyone else would pick as the cutest.
WOOD: Yes. Correct.
KESTENBAUM: So what did you pick?
Ms. WOOD: I chose the cat - the kitten, I should say - for two reasons: One was it was the least appealing to me, which I find is generally the case. I'm always on the outside, in my opinion.
KESTENBAUM: Marla picked the kitten, even though, personally, she found it the least cute. Imagine if this were to happen in the stock market.
What if the market was entirely filled with Marlas, right? Then basically, you know, there's a huge kitten bubble. And no one actually thinks kittens are cute.
PROF. RIVOLI: And there we have the subprime.
KESTENBAUM: The subprime housing bubble. Even if you thought it was a bubble, there was still someone else willing to buy. So it made sense to stay in the game.
All right, here are the results from our experiment. People in Group A, asked what they thought was the cutest: The kitten was the winner. People in Group B, asked what they thought everyone else would pick: 75 percent did get it right -The kitten. But 25 percent 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.
Pietra Rivoli says when she hears on the news about the stock market doing this or that, she sometimes thinks: beauty contest.
PROF. RIVOLI: There's been some academic research on this that says, you know, there's a lot of price movement in individual stocks - and in the market as whole - that we can't explain, you know, with kind of fundamental, rational stories.
KESTENBAUM: This does not mean the stock market is totally nuts. Over long stretches of time, she says, even John Maynard Keynes would probably argue the stock market gets things right. All bubbles eventually pop.
David Kestenbaum, NPR News.
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