STEVE INSKEEP, Host:
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.
PIETRA RIVOLI: It made sense for me immediately. And I thought it had such interesting implications.
KESTENBAUM: 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: 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.
KESTENBAUM: What do you think is cutest?
PROF: 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.
MARLA WOOD: I actually had a hard time finding any of them particularly cute - oddly.
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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?
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: 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: 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.
INSKEEP: Pietra Rivoli says when she hears on the news about the stock market doing this or that, she sometimes thinks: beauty contest.
PROF: 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: David Kestenbaum, NPR News.
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INSKEEP: It's MORNING EDITION, from NPR News.