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Keynes likened stock markets to the beauty contests of his day. During the early 1900s, the
London newspaper would print 100 photos of beautiful women. You had to write in with the six
women you liked the most. Everyone that picked the most popular woman could win a prize.

Here is the twist: If you simply picked the women YOU thought was pretty, you wouldn¶t win,
because your entries have to match the popular vote. So you didn¶t pick the women you liked;
you didn¶t even pick the women you thought a panel of judges might think were beautiful. You
had to pick those women whom you thought that everyone else thought that everyone else liked!

Get it? You¶d have to vote based on what you¶d think average opinion thinks average opinion is.
Keynes¶ beauty contest explanation always reminds me of a conversation I often have with my
husband. Strangely, it only occurs when we¶re deciding where to go for dinner.

³Honey, where do you want to eat tonight?´

³I think that you think I want to go for Mexican. But I know that you know that I want to go
where you want to go.´

(On days like these we end up cooking at home.)

But when it comes to the stock market, this sort of thinking works. Here is the beauty contest in
Keynes¶ own words: ³It is not a case of choosing those [faces] 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
practice the fourth, fifth and higher degrees.´
So how can you profit from Keynes beauty contest theory? Quite simply, anticipation of what
average opinion expects average opinion to be is reflected in a stock¶s PE ratio. If all investors
expect all investors to buy into a stock, its PE ratio will be higher than normal.

You see, the return on a stock doesn¶t just depend on its earnings growth. Return on a stock is
also heavily dependant on whether earnings growth exceeded what investors expected.

This is where investors play the beauty contest game. If an investor believes that all other
investors believe that a company will exceed expected growth, they will buy the stock. Take
Blue Nile Inc. for example. In late March, I recommended this online diamond jewelry retailer
for my subscribers.

The stock went up nearly 12% in one day when the company announced earnings. This is
because investors were practicing the second degree ² ³I think that everyone else thinks this
stock will go up, so I¶ll buy it today too.´

But the key to winning in the stock market is to get in before the frenzy starts ² like we did with
Blue Nile. And you can do that only through due diligence and buying those stocks that YOU
think are sound investments. That is, according to Keynes, investing in the first degree.

The lesson from a forgotten beauty contest theory is this: You need to get in before the ³I think
that they think´ guys start buying.