The Beauty Contest and Short‐Term Trading

• Published date: 01 October 2015
• DOI: http://doi.org/10.1111/jofi.12279
• Date: 01 October 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 5 •OCTOBER 2015

The Beauty Contest and Short-Term Trading

GIOVANNI CESPA and XAVIER VIVES∗

ABSTRACT

Short-termism need not breed informational price inefficiency even when generating

beauty contests. We demonstrate this claim in a two-period market with persistent

liquidity trading and risk-averse, privately informed, short-term investors and find

that prices reflect average expectations about fundamentals and liquidity trading.

Informed investors engage in “retrospective” learning to reassess inferences (about

fundamentals) made during the trading game’s early stages. This behavior introduces

strategic complementarities in the use of information and can yield two stable equilib-

ria that can be ranked in terms of liquidity,volatility, and informational efficiency.We

derive implications that explain market anomalies as well as empirical regularities.

It might have been supposed that competition between expert profes-

sionals [...] would correct the vagaries of the ignorant individual left to

himself. It happens, however, that the energies and skill of the profes-

sional investor and speculator are mainly occupied otherwise. For most of

these persons are [...] largely concerned, not with making superior long-

term forecasts [...] but with foreseeing changes in the conventional basis of

valuation a short time ahead of the general public. (Keynes, The General

Theory of Employment, Interest and Money,1936)

DOES SHORT-TERMISM BREED informational price inefficiency? We find that this

need not be the case, even when “beauty contests” arise, provided that liquid-

ity shocks are persistent. We examine this question in a two-period market

where short-term, informed, competitive, risk-averse agents trade on private

information and accommodate liquidity supply while facing persistent demand

from liquidity traders.

∗Cespa is with Cass Business School, City University of London, CEPR, and CSEF; Vives is

with IESE Business School. A previous version of this paper was circulated under the title “Ex-

pectations, Liquidity, and Short-Term Trading.” For helpful comments, we thank the Co-Editor

(Bruno Biais), the Associate Editor, and two anonymous referees as well as Elias Albagli, Sne-

hal Banerjee, Max Bruche, Giacinta Cestone, Hans Degryse, Marcelo Fernandes, Itay Goldstein,

Terry Hendershott, Peter Hoffmann, Harrison Hong, Peter Kondor, Jean-Paul Laurent, Olivier

Loisel, Stephen Morris, Richard Payne, Ioanid Ros¸u, Kristien Smedts, Gunther Wuyts, Lian Yang,

Kathy Yuan, and participants at numerous seminars and conferences. Cespa acknowledges fi-

nancial support from ESRC (grant no. ES/J00250X/1). Vives acknowledges financial support from

the European Research Council under the Advanced Grant project Information and Competition

(no. 230254) and from project ECO2011-29533 of the Spanish Ministry of Science and Innovation

at the Public-Private Sector Research Center at IESE.

DOI: 10.1111/jofi.12279

2099

2100 The Journal of Finance R

Traders’ “myopia” ranks high on the regulatory agenda, due to concerns about

the possibly detrimental effects of such myopia on the market.1Such concerns

have a long tradition. For instance, short-term trading is the very basis of

Keynes’s dismal view of financial markets. According to his beauty contest

analysis, traders’ investment decisions are driven by anticipation of their peers’

changing whims and not by actual knowledge of the companies they trade. As

a result, competition among informed traders does not necessarily counteract

the actions of uninformed traders.2Some researchers argue that this type of

behavior introduces a particular form of informational inefficiency whereby

traders tend to put a disproportionately high weight on public information in

their forecast of asset prices (see Allen, Morris, and Shin (2006)). Furthermore,

anticipation of short-term price movements may induce market participants to

act in a way that amplifies such movements (Shin, 2010) and thereby contribute

to crashes.

We show that the beauty contest analogy for financial markets tells just part

of the story because, when liquidity traders’ demand shocks are persistent,

prices reflect average expectations about not only fundamental value but also

liquidity trading.

In this paper,we present a two-period model of short-termtrading with asym-

metric information in which investors observe an exogenous public signal—in

the tradition of dynamic noisy rational expectations models (see, for example,

Singleton (1987) and Brown and Jennings (1989)). We find that if liquidity

trading is persistent, then there is strategic complementarity in the use of

private information. We provide sufficient conditions for that complementarity

to generate multiple extremal stable equilibria that can be ranked in terms

of price informativeness, liquidity, and volatility. In particular, we find that

there are two extremal equilibria: a high information equilibrium (HIE) and

a low information equilibrium (LIE). At the HIE, prices are good signals of

the underlying fundamentals, volatility is low, and liquidity is high. The LIE

displays the opposite properties in terms of informational efficiency, volatility,

and liquidity.

1While the market presence of traditionally long-term investors such as institutions has steadily

increased over the last two decades, their holding period has decreased substantially (see OECD,

http://www.oecd.org/daf/fin/financial-markets/48616812.pdf). Haldane and Davies (2011)examine

a large panel of U.K.- and U.S.-listed companies over the period from 1980 to 2009. They find

compelling evidence of investors’ short-term bias, which is even more pronounced in the last 10

years of their sample.

2“Or, to change the metaphor slightly, professional investment may be likened to those newspa-

per 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. And there are some, I believe, who practise the fourth, fifth and higher degrees.” (Keynes, The

General Theory of Employment, Interest and Money,1936).

The Beauty Contest and Short-Term Trading 2101

In a model identical to ours but with transient liquidity trading (and without

an exogenous public signal), Allen, Morris, and Shin (2006) find that prices

(i) are driven by higher order expectations (HOEs) about fundamentals, (ii) un-

derweight private information (with respect to the optimal statistical weight),

and (iii) are farther away from fundamentals than investors’ consensus. The

same result obtains in our setup when liquidity trading is transient. A similar

result also holds at the LIE when liquidity trading is persistent. However,at the

HIE we find that the price is more strongly tied to fundamentals (as compared

with investors’ consensus) and overweights average private information (as

compared with the optimal statistical weight).3Therefore, the beauty contest

feature of asset prices does not necessarily imply that prices are worse esti-

mators of fundamentals compared to consensus, nor does it imply that prices

exhibit inertia or react slowly to changes in fundamentals. Thus, by establish-

ing the limits of the beauty contest analogy for financial markets, we refute the

view that short-term trading always amplifies demand shocks or necessarily

leads to uninformative prices or “excess” volatility.4We also identify circum-

stances under which informed traders stabilize the market by counteracting

the actions of liquidity traders (at the HIE). Finally, we deliver sharp predic-

tions on asset pricing that are consistent with the received empirical evidence

(including noted anomalies).

A crucial hypothesis of our model is that liquidity trading displays persis-

tence. This hypothesis can be viewed as a reduced-form assumption on the

effect of the performance-flow relationship on the holdings of mutual funds.

Coval and Stafford (2007) show that mutual funds facing aggregate redemp-

tion orders will curtail their positions and engage in “fire sales.” This dynamic

generates temporary and allegedly uninformed price pressure that reduces

fund performance. As shown by evidence on the performance-flow relation-

ship (Chevalier and Ellison (1997), Sirri and Tufano (1998)), poor performance

breeds investor redemptions, thus leading to further fire sales. The implication

is that uninformed orders can display persistence. Building on this intuition,

Lou (2012) tests a capital flow-based explanation for some well-known empiri-

cal asset pricing regularities and finds that mutual fund shareholdings display

strong persistence at a quarterly frequency.5

Campbell and Kyle (1993) follow a different approach and disentangle the

properties of the noise process from the properties of returns. These authors

find that liquidity traders’ positions are highly persistent at an annual fre-

quency.I n sum, the persistence of liquidity trading appears to be a natural and

plausible assumption that is backed by empirical evidence.

3In a related paper,we show that a similar conclusion holds in a model with long-term investors

(see Cespa and Vives (2012)).

4Part of the debate over the consequences of short-term trading revolves precisely around its

alleged negative effect on the informativeness of asset prices (see, for example, “Kay review of UK

equity markets and long term decision making,” available at http://lawcommission.justice.gov.uk/

docs/kay-review-of-equity-markets-final-report.pdf).

5Our model should be understood to fit low frequency (i.e., monthly to quarterly) patterns.