Bitcoin’s Beauty Contest
Learning about the forces driving prices can help you make the best possible decisions.
If you’ve ever taken an economics class or even read anything on the subject, you’ll have heard of John Maynard Keynes.
He’s one of the most influential economists ever, with an entire branch of the field named after him. In 1936, Keynes published his final book: The General Theory of Employment, Interest and Money.
Yes, that’s probably the last book you’d choose as bedtime reading or to take on holiday. The General Theory might also be the last place you’d look for insights about Bitcoin prices, considering it’s over eighty years old. Keynes helped create the financial system that Bitcoin aims to replace after all. So it might seem like his work is outdated and irrelevant.
But Keynes is arguably more relevant than ever. The twelfth chapter of The General Theory includes a brilliant insight that can shed light on the forces behind Bitcoin prices.
Satoshi Nakamoto (pseudonym for the person or group who created Bitcoin) alluded to a similar idea in an early forum post suggesting it may even have provided inspiration for the first cryptocurrency.
In this post, we’re going to look at the Keynesian beauty contest. It’s a simple yet powerful idea that can help you make the best possible decision next time you buy Bitcoin, or if you’re planning to invest for the first time.
The Keynesian beauty contest
Imagine that you are in a room with ninety-nine other people, competing to win a share of a cash prize. You are each asked to pick a number between one and one hundred. The number you choose will determine what percentage of the prize you receive.
But there’s a catch. The winning number is not random. Instead, it’s the number picked by the most other people. The closer your choice is to that number, the more money you win.
So, what do you pick? You might like to select 77 because that’s your lucky number. But perhaps you feel other people are likely to choose a round number, such as 50.
Seeing as you have some time to decide, you start discussing it with a few other people in the room. They share their theories. Someone claims they have discovered a system for getting the right answer and can sell it to you. Others point to statistics or study the results of similar competitions in the past. Some pick at random.
That hypothetical competition is the perfect metaphor for asset prices.
Keynes described stock prices as like a beauty contest. He imagined a competition where entrants chose their six winners from 100 photographs of faces. Those who chose the most popular faces won a prize.
As Keynes pointed out, few entrants would choose the face they found most attractive. Instead, they would consider what most people find most attractive. A smart entrant would think about what most people think most people think. Some might even think about what most people think most people think most people think.
The result is a circular logic that has little to do with the faces and everything to do with perception.
Bitcoin’s beauty contest
Keynes had the stock market in mind, but the same idea applies to any investment — especially Bitcoin.
Prices are not always based on what people see as the fundamental value of Bitcoin. They’re based on what people think other people think is the value of Bitcoin.
Many investors buy cryptocurrencies because they expect the price to increase, rather than because they understand the fundamental value.
For example, let’s say the price of Bitcoin is £10,000. A hypothetical investor called Max believes it will rise to £100,000. Max has done his research and thinks other investors will keep buying until it reaches that. So he buys Bitcoin, expecting to 10x his money.
Is that a good or bad decision? It depends.
If Max understand the technology and bases his projection on the potential future value, he’s making a good decision. Max is basing his investment on the underlying value and he has done his research first.
But if the only thing Max knows about Bitcoin is that he expects other people to keep buying until the price reaches £100,000, it’s not such a smart decision. This line of thinking can lead to investors buying because they don’t want to miss out. A runaway market may be the result.
Keynesian beauty contest thinking may have contributed to the price spike in 2017. Since then, prices seem to be evening out to a more realistic level, with investors considering the practical uses of Bitcoin and not focusing so much on what the price might be in the future.
Luno doesn’t take a stance on Bitcoin prices, but we believe it’s important to have a clear strategy for your investments and to make sure you don’t get carried away if you can’t afford to do so. Learning about the forces driving prices can help you make the best possible decisions.