Thanks to another week of volatility in the markets, we are again face-to-face with the fact that there is absolutely no sensible reason for the movement of stock and derivatives prices.

It is at times like these that one recalls Keynes’ beauty contest analogy. In it, a newspaper displays a set of attractive young women and holds a contest in which entrants are encouraged to choose who they think is the most beautiful. The winners of the contest will be all the entrants who choose the most beautiful girl. But, since there is no impartial judge, the most beautiful woman is determined by the number of votes she receives. The winners, then, are those who choose the woman who is chosen by the majority—id est, the winners are the majority. As such, a rational entrant will not pick the woman he thinks is most beautiful, opting instead to pick the woman he thinks everyone else will think is most beautiful. His choice would be based, not on his own tastes, but rather on his perception of the average taste of all the entrants.

This strategy does not end there, however, since the rational entrant will realize that the other entrants will base their choices on the average taste as well, and so he would then base his choice on his perception of the average perception of the average taste. As Keynes explained, “It is not a case of choosing those that, to the best of one’s judgment, are really the prettiest, nor even those that 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.”

To a large extent, the stock market is no longer focused on the buying and selling of ownership in companies. Investors have found that there is much more money to be made—and at a much quicker rate—in the buying and selling of the public perception of the companies, just as it is in the beauty contest. It is a sort of bet on the direction in which the public will sway—whence the expanding market of derivatives of securities. An entire sector is dedicated to the purchase and sale of futures contracts, which is a way to invest in the future exchange price of a stock or commodity, something of a bet on a bet. A credit default swap is something of a bet that the bet on someone else’s bet will go awry. It would be an instructive exercise to see how many layers of bets the most complex derivative on the market is made of.

Luckily, we have at our disposal a document that lays out exactly how to read other investors and thus make the best choice based on their choices. Here it is in its entirety: