Warren Buffett's Reading List: John Maynard Keynes & A Beauty Contest

“Human nature desires quick results,” writes Keynes. “There is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.”

Last month, I wrote about two chapters from The Intelligent Investor that Warren Buffett has credited with changing his life. On occasion, though, he adds a third chapter (from an entirely different book) onto his must-read list.

“There’s one chapter in [John Maynard Keynes’s] General Theory that relates to the psychology of markets and the behavior of market participants,” Buffett told shareholders at Berkshire Hathaway’s annual meeting in 1994. “You’ll get as much wisdom from reading that as anything [else] written on investments.”

While Keynes remains best known for his various economic theories and whatnot, his greatest insights (in my opinion) are of a psychological nature.

Every time I read Chapter 12 of The General Theory of Employment, Interest, and Money (“The State of Long-Term Expectation”), I gain a greater appreciation for Keynes’s matter-of-fact appraisal that while we might fancy ourselves eminently rational creatures, it’s really so-called “animal spirits” that move both the markets and us.

And, while all of Keynes’s semicolons and paragraph-length sentences can be a little grating, he nevertheless writes in an evocative style that sticks in the reader’s mind.

“We are merely reminding ourselves,” says Keynes, “that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.”

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✨ It’s really, really hard to be confident about a business’s prospects in the long run — making the siren song of short-termism all but impossible to resist.

“Most [expert professionals] are, in fact, largely concerned not with making superior long-term forecasts of the probable yield of an investment over its whole life,” writes Keynes, “but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.”

“They are concerned not with what an investment is really worth to a man who buys it ‘for keeps’ — but with what the market will value it at, under the influence of mass psychology, three months or a year hence.”

In a footnote, Keynes adds that “when Wall Street is active, at least half of the purchases or sales of investments are entered upon with an intention on the part of the speculator to reverse them the same day”.

Forget a time horizon of years or decades. We’re talking minutes or hours here.

Succumbing to this short-term thinking means that you eschew an entrepreneurial mindset (focused on business fundamentals) for that of a speculator who cares only if the stock price goes up or down tomorrow. That’s not exactly the road to riches.

“Human nature desires quick results,” notes Keynes. “There is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.”

✨ What makes all of these chapters so timeless is that each one can be summed up in an enduring image or phrase. Chapter 8 of The Intelligent Investor introduces us to Mr. Market, that memorable manic-depressive who shouts prices all day. Chapter 20, meanwhile, explains the key concept of “margin of safety”.

And Chapter 12 of The General Theory is no exception — with Keynes comparing the investment process to a newspaper beauty contest.

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.

It is not a case of choosing those 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.

For something that is ostensibly about choosing the most beautiful person, the situation quickly devolves into the player twisting himself into knots trying to predict which faces the others will pick — with his own opinion hardly a consideration.

The comparison to the money game is clear: When investors stop trying to identify and purchase the best businesses with the most profitable yields over the long run, they are left to guess what the “average opinion expects the average opinion to be” and how that will affect the short-term prices of stocks.

Warren Buffett once said, “You really should not make decisions in securities based on what other people think. A public opinion poll will not get you rich on Wall Street.”

That’s exactly what Keynes warns about in his beauty contest example. A crippling paralysis by analysis wherein everyone else’s opinions (or at least what you guess those opinions to be) matter more than your own convictions.

✨ Keynes packs a lot into this chapter — so here are a few more odds and ends that stood out to me.

• “The State of Long-Term Expectation” holds a special place in my heart because it inspired my all-time favorite investing book, The Money Game (written by George Goodman under the pseudonym Adam Smith). In the introduction to The Money Game, the author marvels at one of Keynes’s lines from this chapter: “The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”

  • From there, Goodman races off on a fascinating exploration of psychology and behavior that lays bare the many foibles and follies of Wall Street.

• Keynes really wrestles with the pros and cons of liquidity — and whether or not investing should be regulated like gambling. In particular, he seems to lament how liquid markets disperse ownership of a business so widely (and to investors who do not fully understand said business). “The element of real knowledge in the valuation of investments by those who own them or contemplate purchasing them has seriously declined,” he writes. “A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently … due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady.”

  • On the flip side, Keynes admits that liquidity calms investors’ nerves and makes them more likely to put their capital into the market in the first place. “Indissoluble” investments might lead to better decisions overall, but it would leave many would-be investors sitting on the sidelines.

• In a similar vein, Keynes identifies “animal spirits” as an inescapable factor of investing. No matter what we tell ourselves, our economic decisions are not solely driven by cold, hard logic and quantitative rationality — but by optimistic urges and the call to financial adventure. And, he notes, that’s not necessarily a bad thing. “Only a little more than an expedition to the South Pole, is [investment] based on an exact calculation of benefits to come. Thus, if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.”