English Economist John Maynard Keynes famously compared financial markets to a strange sort of beauty pageant run by London newspapers in his time. The papers published an array of photos, and readers could enter a contest in which the winner was the reader who guessed which faces would be chosen by the most other participants. As Keynes pointed out, it would not do to simply choose the photo that one found most attractive, for one’s own tastes might not match those of other entrants. Neither, however, should one choose the photo that one thought other entrants would find most attractive (for they would not themselves be choosing the one they found most attractive). Each entrant would, rather, be trying to guess what other entrants would guess about which photos most other entrants would choose.
In the same way, participants in the stock market, Keynes argued, did not generally attempt to estimate the likely returns from a company’s investments (often referred to these days as its “fundamentals”), but to “guess better than the crowd how the crowd will behave.” If other market participants are, for whatever reason, buying a particular kind of asset and driving up its price, rational participants would decide to buy as well (to benefit from the short-run increase in prices) as long as they expected that the price would continue to rise. *
This makes sense, from the standpoint of an individual buyer, even if the buyer, in some sense, knows better— that is, believes that the company in question has bad long-term prospects, that “the market” has overpriced the stock that other buyers are acting unwisely, and so on. For example, I may not think that Springfield Nuclear Power is a very well-run company, but as long as I think other people are (unwisely) going to buy its stock, pushing up the stock price, it makes sense for me to buy the stock and profit from these future price increases. As more people buy in to take advantage of a crowd-induced rise in prices, of course, they further fuel the growth of the bubble. These price increases, in turn, may induce still others to buy the stock in anticipation of further increases, and so on.
This process can dramatically unhitch the price of an asset from its “fundamentals,” at least for a time. However, in the long run fundamentals matter both on the company and global economic levels. That’s what makes the investing “Journey” so challenging for so many. The ability to not react to news that moves the market on a short term basis is key to reaching your destination.